> > > I'm disturbed by the tone of this
discussion, implying that most of > accounting research/publication is
just a big game.

I think it is fair to say that some members of this
group view accounting research as a game, and a rigged one at that. Other
members of this group do not share that view. Keeping these different
perspectives in mind is helpful when trying to make sense of the discussion.

Richard

June 17, 2009 reply from Bob Jensen

Hi Richard,

I think you're correct Richard, but until academic accountics researchers
and their leading journals begin to take replication more seriously, it's
very hard to believe in non-replicated harvests of accountics research.
Those that are truly serious about accounting research must become more
serious about authenticating accounting research.

Perhaps it would seem less of a game if independent researchers took the
trouble to replicate findings. On occasion there are some replications (such
as the verification of Eric Lie's stock options backdating research), but
publication of replications is indeed rare.

> I'm disturbed by the tone of this discussion,
implying that most of > accounting research/publication is just a big
game. It seems to demean our
> efforts in a Pogo-like way (we are being our own worst enemy if we
don't
> respect our own work). Does some game-playing occur? Undoubtedly. Is
it
> the norm? I don't think so (though it's always possible that I'm naive
and
> out-of-touch)

A Pogo-like way is healthy because Pogo was
thoughtful enough to face some realities. I have done considerable work on
the structure of the US academy (as has Bob) and the way Bob characterizes
it is closer to the truth -- when work deserves to be disparaged,
intellectual honesty compels us to disparage it. At an AAA meeting a number
of years ago I listened to an editor of one of our most prominent US
accounting journals offer the following alternative hypothesis to the one
that the academy was structured to advance accounting knowledge: "We have
constructed a game to identify who the cleverest people are so we know who
to give the money to."

The research on the structure of our academy, if
viewed with an open, Pogo-like mind suggests that this alternative
hypothesis is more credible than one of being honestly engaged in
understanding (if that were the case our research would not be almost
entirely structured as tests of conventional economic theories that are
constructed not be testable).

I have served numerous times on our university's
promotion and tenure committee. I chaired it this past year. I have reviewed
the dossiers of people from many disciplines. In the process I have learned
quite a bit about the cultures of other disciplines. The discussion about
multiple authors, which is the rule in the hard sciences (sometimes there
are literally dozens of them), is an interesting contrast. Those disciplines
have developed protocols on the order of author listing (it isn't
alphabetical) that reflects the relative contributions of the authors to the
project.

I've seen people denied tenure because they were
not the "lead" author on enough papers. It is a system that is
self-reinforcing. Is it abused? Sure, what one isn't, but it seems to work
reasonably well. Accounting has no such protocol. At my shop we have reached
the point where the same credit is given to a person on a three-author paper
as is given to a person with a single authored paper. Without the protocol
that exists in the natural sciences on credit for multiple authors, there is
little other way to describe our process as other than a game.

Another protocol in the laboratory or bench
sciences is the maintenance of a lab journal. You can always spot a lab
scientist at our faculty senate meetings because they are the people taking
notes in a bound journal (a diary). Because replication is crucial to
science, there is a moral imperative that an experimental scientist keep a
precise record of each step in the experimental process. He or she must
provide the exact recipe so that any scientist is able to produce the
result. (One of the most interesting studies of the sociology of science
involved the lab journals of Millikin reporting his various iterations of
the oil-drop experiment; guess which ones he published -- you guessed it --
the ones most consistent with his prior beliefs.

Without those lab journals, this knowledge would be
lost forever). Most of the work published in our leading accounting journals
is laboratory work (accountics, as Bob describes it). Data are gathered
(usually selected from a publicly available data source) and all manner of
choices are made by the experimenter in conducting the experiment before the
final published result is obtained. For example, do we know what truncation
decisions were made or how many different models were run before the
published one arose? But we have no requirement that the experimenter keep a
detailed log of all of these choices. We have to rely on the recipe given in
the article itself, which is seldom sufficient to replicate what was
actually done.

When Bill Cooper suggested that the AAA require
authors publishing in TAR to provide their data (not their logs, because
they don't have them) to the public, our noted accounting scientists
screamed bloody murder. We still have only a voluntary disclosure policy. If
we were truly serious about learning something from our work, we would
mandate that sufficient information be provided to allow anyone to replicate
the experiments before we publishe the results. That we don't do that may
say something about us.

For the interested: Adil E. Shamoo and David B.
Resnik, Responsible Conduct of Research, 2003, Oxford University
Press. I took a course in this taught by one of NC State's philosophers.
There is a huge literature on appropriate research conduct in the sciences
(social and natural). In accounting there is practically none. For a
discipline whose alleged expertise is "controls" we have virtually none over
the research process. Guess we are all saints.

To be clear about what I think (as if anybody
cares), I think that a substantial amount of game playing takes place, but
accounting research itself does not need to be characterized as a game. I
believe that (1) there are many incentives to manipulate the system for
personal gain, (2) many accounting professors participate in the system and
play games because they are forced to participate and game playing seems to
be efficient and effective, and (3) there are enough ethically challenged
amongst the accounting professoriate to justify a general world view of
skepticism.

Dave Albrecht

June 20, 2009 reply from Bob Jensen

Hi David,

I wish I could repeat some private messages I'm
receiving from accounting professors about (ratting?) how some of their
colleagues are gaming the research/publishing system.

Most mention a 99-1 model or its near-equivalent.
Others mention the 98-1-1 model. The worst is a message revealing a
94-1-1-1-1-1-1-model.

Of course I believe many, probably most, joint
authoring efforts are legitimate for reasons astutely mentioned by Ron
Huefner. But there also is a lot a gaming going on.

Paul Williams notes that at every juncture empirical
accounting researchers make subjective decisions that make it almost
impossible to truly replicate outcomes. In a private message he notes that a
top researcher (who chaired a lot of doctoral dissertations) made an
on-campus presentation in which he admitted to 16 times in his research
study being presented where he made decisions that would've made it
virtually impossible to independently replicate his work. The source of the
data was a commercial database that can be purchased by anybody, but it
alone would not have been sufficient for research outcomes authentication.

It would seem that if the top research journals
announced a change in policy and invited submissions of research
replications there might be few submissions that actually authenticate
earlier published outcomes. Until accounting
researchers commence keeping "lab journal" (and making them available to
teams of authentication researchers) I doubt that there will be serious
replication of empirical academic accounting research. Until then we must,
in the words of Paul Williams, regard our empirical accounting researchers
as "saints."

What's more disheartening are
reports of failed efforts to replicate the empirical results of some of the
AAA's Seminal and/or Notable contributions award winners. The makes me
wonder if another type of gaming (selectively massaging of data) is going on
at the highest level of prestige in academic accounting research.

1. Free ridership should bother the culprit more
than the rest. The culprit will establish a reputation and soon the number
of people willing to collaborate with the person will dwindle.

Unless of course, the person also establishes
reputation as a saint. I have heard of many free-riding saints in
accounting.

2. I think requiring publicly disclosed lab journal
is a very good idea. I also favour replications, provided the design of each
original as well as replicated study is authenticated by a statistician and
a domain expert (economics, finance, psychology,...). Some adult supervision
may not be a bad idea if we are unwilling to seek collaborations with other
disciplines.

3. I personally believe a good solution for
accounting is a Darwinian one: Shut down all establishment journals and let
the "market" decide. The fittest results will survive in the long run.
Establishment journals are riddled with moral hazard in the absence of
observability and replications. This solution will also prevent the
development of ayatollahs pretending to be editors and referees. (Of course
there are many good editors and referees, but they are, in my opinion
exceptions). Sunshine is a good disinfectant.

I say the above in spite of the fact that my own
personal experience has not been that bad (most papers I chose to send to
accounting journals were accepted, but many of the inane comments even on
papers accepted and the fact that some were accepted in spite of their
mediocrity drive me to this conclusion).

Regards,

Jagdish S. Gangolly
Department of Informatics College of Computing & Information
State University of New York at Albany Harriman Campus,
Building 7A, Suite 220
Albany, NY 12222
Phone: 518-9568251

What happens to U.S. GAAP literature when the Codification goes live on July 1,
2009?All
existing standards that were used to create the Codification will become
superseded upon the adoption of the Codification. The FASB will no longer
update and maintain the superseded standards. Also, upon adoption of the
Codification, the U.S. GAAP hierarchy will flatten from five levels to
two­authoritative and non-authoritative. The following table illustrates the
result:

DON’T BE CAUGHT OFF GUARD! GET READY FOR THE CODIFICATION!

The FASB is expected to institute a major change in the way accounting standards
are organized. The FASB Accounting Standards CodificationTM is
expected to become the single official source of authoritative, nongovernmental
U.S. generally accepted accounting principles (GAAP).After final
approval by the FASB only one level of authoritative GAAP will exist, other than
guidance issued by the Securities and Exchange Commission (SEC). All other
literature will be non-authoritative.While the FASB Codification is designed to make it much easier to research
accounting issues, the transition to use of the Codification will require some
advance training. These weekly “Countdown to Codification” alerts are designed
to provide tips to make that transition easier.The FASB offers a free online tutorial at
http://asc.fasb.org. A recorded instructional webcast­The Move to
Codification of US GAAP, first presented live on March 13, 2008­also is
available at
http://www.fasb.org/fasb_webcast_series/index.shtml. In addition,
Codification training opportunities are offered through professional accounting
organizations such as the American Institute of Certified Public Accountants (AICPA).

As of June 20, 2009 there
is still some question whether faculty, students, and colleges will get the a
free deal on the $150 basic version or the $850 professional version that
includes cross referencing.

The following message was
forwarded by David Albrecht on June 16, 2009

On July 1, 2009, the Financial Accounting Standards Board (FASB) is
instituting a major change in the way accounting standards are organized. On
that date, the FASB Accounting Standards Codification™ (FASB Codification)
will become the single official source of authoritative, nongovernmental
U.S. generally accepted accounting principles (U.S. GAAP). After that date,
only one level of authoritative U.S. GAAP will exist, other than guidance
issued by the Securities and Exchange Commission (SEC). All other
literature will be non-authoritative.

As part of its educational mission, the Financial Accounting Foundation (FAF),
the oversight and administrative body of the FASB, in a joint initiative
with the American Accounting Association (AAA), will provide faculty and
students in accounting programs at post-secondary academic institutions with
the Professional View of the online FASB Codification.

Accounting Program Access—No Cost to Individual Faculty or Students
The Professional View of the FASB Codification will be accessible at no cost
to individual faculty and students, through the AAA’s Academic Access
program, available to Registered Accounting Programs. The Professional View
will provide advanced search functions with special utilities to assist in
the navigation of content, representing the fully functional view of the
FASB Codification that will be used by auditors, financial analysts,
investors, and preparers of financial statements. All of the features that
have been available with the verification version currently at
http://asc.fasb.org are included with the Professional View.
AAA Academic Access

The AAA will provide direct services to accounting departments through its
Academic Access program; issuing authentication credentials for faculty and
students through Registered Accounting Programs, at a low annual
institutional fee of $150. Information about this program will be
forthcoming directly from AAA and on the AAA website at
http://aaahq.org/FASB/Access.cfm.

Transitional Access—From July 1 through August 31, 2009
The AAA will provide credentials to individual faculty and students, at no
charge, during the transition period before the beginning of the fall
semester when faculty and students will receive credentials for access
through their Registered Accounting Programs.

The FAF, FASB, and AAA are enthusiastic about this new initiative and
understand the value of this program to accounting education and
scholarship, in addition to its benefit to faculty and students to have
access to the advanced view of U.S. GAAP that will be used by accounting
professionals.

******************
This advertisement was sent to you from the American Accounting Association.
This message includes valuable information about upcoming events hosted by
the American Accounting Association. If you no longer want to receive email
announcements from us, please send an email to
office@aaahq.org with "EMAIL OPT-OUT" in the subject line.
American Accounting Association | 5717 Bessie Drive | Sarasota, FL
34233-2399 | Phone: (941) 921-7747 | Fax: (941) 923-4093 |
Office@aaahq.org

June 24, 2009 UpdateThere was some doubt initially about whether the free or discounted faculty
and student access version of the FASB Codification database would be the
"Professional" version (that includes searching and cross-referencing at an $850
single user license per year).

The AAA registration site for the discounted ($150 annual discount price)
version makes it clear that accounting education departments or schools will get
the full "Professional" version at a discount, thereby saving each academic
program $700 per year savings per license. What is not yet perfectly clear is
whether this is a single-user access license. My reading is that multiple users
within a department or school can use the Codification database at the same
time. I could be wrong.

Since all future financial statements will no longer reference hard copy
sources like FAS 166 or EITF 98-1 or FIN 48, it is vital for students and
teachers and researchers to have access to the Codification database for
financial statement analysis.

Good News
An Accounting Education Department’s $150 license can be used by multiple
faculty members and students simultaneously, which is indeed good news.

It’s not yet clear how an accounting department will
facilitate multiple-user access, but I guess we will learn that very soon. For
example how can students and faculty off campus access the $150 professional
version of the Codification database.

Codification of the FASB standards, interpretations, and other hard copy FASB
documentation into a searchable "Codification" database, like the road to hell,
is paved with good intentions. Bits and pieces of hard copy dealing with a given
topic are scattered in many different hard copy FASB references and bringing
this all together in newly coded Codification numbered sections and subsections
is a fabulous "paving" idea.

At least Codification of FASB hard copy was a great "paving" idea until it
became evident that FASB standards most likely will be entirely replaced by IASB
international standards (IFRS). It's still uncertain when and if IFRS will
replace the FASB standards, but recent events in Washington DC suggest that the
transition will most likely happen at the end of 2014. This means that millions
of dollars and millions of professional work time hours by accountants,
auditors, educators, and financial analysts will be spent using the FASB's new Codification
database that commenced on July 1, 2009 and will most likely self destruct on
December 31, 2014. As I indicated, when and if IFRS will take over is still
uncertain and controversial, but I'm betting the shiny new FASB Codification
database will self destruct in 2014 ---
http://www.trinity.edu/rjensen/theory01.htm#MethodsForSetting

As a result of scheduled obsolescence, what commenced as a Codification smart
idea became dumb and dumber in 2009.

Furthermore, the Codification database has some huge limitations because it
contains only a subset of the FASB hard copy material that it ostensibly is
replacing.

FASB hard copy contains many wonderful illustrations that are, in my
viewpoint, ideal for learning about standards and their interpretations. In
fact many of the illustrations make FASB standards much easier to learn than
IFRS international standards that are illustration-lite. Sadly many of the
best FASB hard copy illustrations were left out of the Codification database
such that these illustrations cannot be located by search and cross
referencing. For example, when teaching the highly complicated FAS 133, the
most important teaching aids for my students were the illustrations in
Appendix A and Appendix B of FAS 133. Most of those wonderful illustrations
are not in the Codification database which, in turn, makes it much less
useful to accounting and finance educators. Dumb! Dumb! Dumb!

FASB hard copy contains much implementation guidance for complicated
questions raised by auditors and their clients, guidance that is not
contained or even cross-referenced in the Codification database. The
huge example here is the massive amount of implementation guidance for FAS
133 rendered by the FASB's Derivative Implementation Guidance Group (DIGG)
---
http://www.fasb.org/derivatives/
The many DIGG documents are difficult to search and cross reference.
Including them in the Codification database would be terrific --- no such
luck. Dumb! Dumb! Dumb!

Financial accounting textbooks, lecture materials, handouts, problem
assignments, and cases do not at the moment reference the Codification
database sections and subsections. Since corporate annual reports, at least
for the next five years, will now have Codification database referencing
rather than hard copy referencing, textbook publishers and educators will
have to revise all these materials. Textbook publishers are probably
ecstatic since all used books will be obsolete. Educators are not so
ecstatic about revising so much of their own teaching material Furthermore,
the financial accounting textbooks used in the 2009-2010 academic year will
be obsolete. Dumb! Dumb! Dumb!

As Pat Walters pointed out, the Codification database does not include
the Conceptual Framework hard copy. This means that the Conceptual Framework
cannot be searched and cross referenced in the Codification database. Dumb!
Dumb! Dumb!

The auditing standards make thousands upon thousands of references to
FASB hard copy references. These will have to be changed to Codification
database references until the Codification database self destructs. Dumb!
Dumb! Dumb!

Accounting firms their clients will have to change vast amounts of
materials to incorporate new Codification database referencing. For example,
PwC will have to spend millions of dollars overhauling its massive Comperio
database and for what? All this time and effort will have been wasted when
the Codification database self destructs in about five years. Dumb! Dumb!
Dumb!

Accounting firms and their clients will have to spend a lot of time and
money training employees on how to use the Codification database that will
self destruct in about five years --- Dumb! Dumb! Dumb!

Accounting software and millions of relational databases of accounting
data will have to be revised for Codification database referencing. And the
revised software will be useful for less than four years of use. Dumb!
Dumb! Dumb!

NASBA will have to revise future CPA examinations for referencing to
Codification database referencing. But when should these revisions take
place since virtually none of the financial accounting textbooks will have
such referencing for at least a year and maybe more? As far as the CPA
examination, the classes graduating in 2010 and 2011 will not have had
textbooks that incorporated the Codification references. It seems a little
unfair to hit candidates with a different referencing system than was in
their textbooks. Dumb! Dumb! Dumb!

This year early adopters of XBRL who tagged their financial statements
with FASB hard copy references will be putting out obsolete XBRL tagging.
All the U.S. standard XBRL tagging software and financial analysis software
will have to be rewritten ---
http://www.cfo.com/article.cfm/13932485/c_2984368/?f=archives
And it will be written for less than four years of use. Dumb! Dumb!
Dumb!

I’ve been
using the Codification database rather intensively on a FAS 133 project
since it became available. I can’t tell you how disappointed I am in content
of the database, the lousy illustrations, and the poor search engine. The
IASB search engine is vastly superior. Dumb! Dumb! Dumb!

The FASB will allow free access to the Codification database. But the
search and cross referencing software is only available for a single-user
license costing $850 per year. What makes electronic databases useful are
the utilities for search and cross referencing. Hence the FASB will be
raking in millions of dollars for a database that self destructs in about
five years. Smart? Smart? Smart?
The only good news is that college accounting departments can obtain
multiple-user licenses for faculty and students at a discounted $150 price.
As an accounting educator should I say thanks, but I have a hard time saying
thanks for something that is dumb, dumb, and dumb.

I'm told that the Codification database was mostly paid for with government
SOX grants. If it was bought and paid for by the government, why does the
FASB need to rake in millions more for the Codification database search and
cross referencing utilities? This is especially bothersome since the FASB
itself will probably give way to the IASB in just a few years. When that
happens the money and intellectual capital we put into the FASB Codification
database all goes down the drain. Dumb! Dumb! Dumb!

So what would've been smart for the FASB at this juncture?
Since the FASB is taking it as a given that it will virtually be out of business
in 2015 (actually it will become a downsized subsidiary of the IASB). The FASB
should forget implementation (selling) the FASB Codification database and
commence full bore into expanding it into an IASB Codification database. Then it
will be ready to roll in 2015 when the IASB standards replace the FASB
standards. FASB standards could be left codified as well such that users can
easily compare what used to be required by the FASB with what is now (after
2015) required by the IASB.

More importantly, the FASB should work 24/7 adding implementation guidelines
and illustrations into an IASB Codification database to make up for the sad
state of international standards in terms of implementation guidelines for
complex U.S. financial contracting. Tons of illustrations should also be added
to the illustration-lite international standards at the moment.

But implementing the FASB Codification database for five years or less is
dumb, dumb, and dumb!

"... This year early adopters of XBRL who tagged
their financial statements with FASB hard copy references will be putting
out obsolete XBRL tagging. All the U.S. standard XBRL tagging software and
financial analysis software will have to be rewritten..."

While there will undoubtedly be some impact to the
current USGAAP taxonomies, I expect it to be minimal. The references that
are currently in the taxonomy are largely in sync with their codification
replacements as the FAF and XBRL US have been working on this expected
transition for some time.

From a mechanical point of view it will be a fairly
simple exercise to "slip stream" in the codification references.

Askaref (which I developed with 2 others) is
designed for handheld internet devices to do that cross-referencing between
line item accounts, XBRL tags, and GAAP references (FASBs, etc). Having gone
through the database machinations to make this function work, I would say
that effort is nontrivial, but not rocket science. Until I see what a
official release of the XBRL tagging for the Codification, I would suggest
that blanket statements are premature about the ease to “slip stream”
references or the rendering of databases as useless. In any event, it will
make users and support individuals mad if this feature is delayed … like the
Boeing 787 dreamliner (the launch date keeps getting delayed and there is a
corresponding loss of value). With respect to XBRL tagging errors being
generated by the inclusion of Codification, it is difficult to get into the
mind of the user/preparer who is selecting the “best match” of a XBRL tag
with an accounting line item. I do agree that referencing the appropriate
GAAP is critical in order to select the “best match” of an XBRL tag. If this
referencing activity is made more difficult or has incomplete links, then it
is logical that more errors will occur.

With regard to textbooks, one fix that I have seen
is a cross reference table which lists textbook pages and their FASB
references with the Codification references. Hardly elegant, but it works.

Zane Swanson

June 28, 2009 reply from Bob Jensen

Hi Louis

I was influenced by the following quotation that does not make it sound
so slip stream and mechanical as firms struggle to update the XBRL tags:

Any company with a scheduled filing date
before July 22 for a quarter ending June 15 or later can opt to file its
report using the out-of-date 2008 taxonomy. The SEC, though, is
encouraging filers to use the current set of data tags. To accommodate
that request, a company with a line item affected by new FASB literature
will have to create its own extensions to the core taxonomy. Not only
would that require extra effort by companies, Hannon lamented that "a
bunch of rogue XBRL elements" not formed the same way from company to
company would inevitably hinder analyses of the effect of FASB's new
pronouncements on financial statements.David McCann, "Speed Bumps for Early XBRL Filers, Users,"
CFO.com,
June 26, 2009 ---
http://www.cfo.com/article.cfm/13932485/c_2984368/?f=archives

I hope you are correct because it will be a race to update all the
tagging software and implement these tags in corporate annual reports before
the FASB Codification archive database self destructs.

Another problem is that companies that are affected by FAS 133 often
refer to DIGG documents that will not be updated for Codification
references. This could lead to rather confusing outcomes where a footnote
quotation from a DIGG refers to Paragraph 243 of FAS 133 and the XBRL tag
refers to Section 8-15-38 of the Codification database that is not part of
the DIGG document.. It will be especially troublesome with FAS 133 since
there is so much FAS 133 hard copy that was left out of the Codification
database such that searches and references of the database cannot even find
many hard copy references originally issued by the FASB.

I don't think it's as easy as you make it sound and for what purpose with
an archival database that will most likely self destruct in such a
relatively short period of time?

On Friday 3 July 2009 and again on Monday 6 July 2009, the IASB will host
two live webcasts to keep interested parties up to date on progress of the
IASB's comprehensive project to replace IAS 39. The webcasts will focus on
the Board's recently published
Request for Information on the feasibility of an expected loss model.
The webcasts will include presentations by two IASB project staff people
followed by a Q&A session where registered participants can send in
questions for the IASB staff to answer. Each webcast, including the question
and answer session, is expected to last around one hour. Details of the
webcasts:

Questions
Didn't anybody think that the FASB's new Codification transition would render
XBRL markups obsolete even before they got off the ground? What about financial
accounting textbooks for next year and the CPA examination?

Answer
I'm certain somebody thought about it, but nobody wanted to shut off this train
smoke on the Codification transition commencing July 1, 2009

There is also the issue that virtually all financial accounting textbooks
purchased by students for the 2009-2010 academic year will be obsolete (I
suspect). Such is life in the fast lane. When will the CPA examination gulp down
the Codification references?

And the Codification transition in 2009 is such a spike in cost and confusion
given that it will probably itself be obsolete around 2014 or thereabouts when
it is replaced by IFRS. Such is life in the fast lane where CEP providers and
software writers and publishers are singing (the stink being train smoke as
standard setters railroad in the changes on express trains):

A solution is said to be coming soon to a thorny
technical issue that had threatened to temporarily render electronic
financial reports tagged in eXtensible Business Reporting Language less
useful than had been hoped.

The source of the problem is the Financial
Accounting Standards Board's new codification of accounting standards, which
is set to take effect July 1. One key advantage of XBRL-prepared electronic
reports is that each data-tagged line item displays references to the
accounting and regulatory rules applicable to that item. That gives users of
the financial statements valuable context for the reported number.

But the current XBRL taxonomy — that is, the set of
tags corresponding to the line items — aligns with the pre-codification
organization of the FASB literature. That means that as of July 1, users of
data-tagged reports will see references to standards that don't match up
with the new codification. A new taxonomy incorporating references to the
newly codified accounting rules is not expected to be released until early
2010.

Neither FASB nor the non-profit entity that is
working to establish XBRL as a financial reporting format in the United
States had announced whether or when a temporary fix for the problem would
be made available. But yesterday, Mark Bolgiano, chief executive of XBRL US,
told CFO.com that one would be ready in July. The two organizations are
working together, he said, to create an extension to the existing 2009
taxonomy that will display the references correctly.

FASB, though, hedged a bit on the July timeframe. A
spokesperson told CFO.com that the accounting standards board is "shooting"
to have the fix ready by the end of the month, but there is no specific
scheduled date.

Even a short delay could affect investors, banks,
and other users of financial statements filed by any of the 500 largest
public companies with fiscal periods ending June 30 — that is to say, most
of them. And to the extent there is any confusion about the accounting
underlying the information in the reports, it could, of course, could cause
some communications problems for finance executives. The Securities and
Exchange Commission earlier this year required those 500 companies to file
financials using XBRL for periods ending June 15 of this year and later.
(About 1,800 more companies have to do so starting with quarters concluding
on or after June 15, 2010, with the rest following a year after that.)

In fact, a late-July or later release of the fix
would likely mean that most of the first wave of XBRL filings — after those
by a small group of voluntary early adopters that included Microsoft and
Pepsico — would contain the incorrect references, according to Neal Hannon,
senior consultant for XBRL strategies at The Gilbane Group, an information
technology consulting firm.

Everybody involved in the production of financial
reports, Hannon said, including software companies and financial printers,
will need some time to understand the solution and make sure it's compatible
with their products, before companies can begin to prepare financials
containng references to the codification accounting standards.

Still, Hannon called the forthcoming solution
"great news," saying he had been concerned for months that the necessary
programming might not prove doable, at least in a reasonable time frame. He
characterized XBRL-tagged financial reports without references to the
current underlying accounting literature as unacceptable. "What would be the
point?" he said.

Even if the fix were delayed, financial-report
users would still be able to locate the accounting standards relating to
specific line items, according to Tom Hoey, FASB's codification project
director. The board's codification website contains a tool that
cross-references the old organization of generally accepted accounting
principles with the new one. "It's not as though people have to be
completely lost," Hoey said, but added, "they might find it more cumbersome
for a short period."

Indeed, Hannon noted that a user would have to run
two programs simultaneously, switching back and forth between an XBRL
software reader and the cross-reference tool, which he said would be
somewhat unwieldy when performing robust analyses of financial statements.

Meanwhile, there is another speed bump for the
early days of XBRL filings: The SEC's Edgar filing database will not be
ready to accept data-tagged reports using the 2009 taxonomy, containing
several FASB rules and interpretations published this year, until July 22.

Any company with a scheduled filing date before
July 22 for a quarter ending June 15 or later can opt to file its report
using the out-of-date 2008 taxonomy. The SEC, though, is encouraging filers
to use the current set of data tags. To accommodate that request, a company
with a line item affected by new FASB literature will have to create its own
extensions to the core taxonomy. Not only would that require extra effort by
companies, Hannon lamented that "a bunch of rogue XBRL elements" not formed
the same way from company to company would inevitably hinder analyses of the
effect of FASB's new pronouncements on financial statements.

The
Worldcom fraud accompanied by one of the largest bankruptcies is characterized
by what, in my viewpoint, was the worst audit in the history of the world that
contributed, along with Enron, to the implosion of the historic Arthur Andersen
accounting firm.

KPMG’s “Unusual Twist”
While KPMG's strategy isn't uncommon among corporations with lots of units in
different states, the accounting firm offered an unusual twist: Under KPMG's
direction, WorldCom treated "foresight of top management" as an intangible asset
akin to patents or trademarks.
See http://www.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud

Punch Line
This "foresight of top management" led to a 25-year prison sentence for
Worldcom's CEO, five years for the CFO (which in his case was much to lenient)
and one year plus a day for the controller (who ended up having to be in prison
for only ten months.) Yes all that reported goodwill in the balance sheet of
Worldcom was an unusual twist.

The first 20 minutes is his presentation, which is
pretty good - but the last 45 minutes or so of Q&A is the best part. It is
something that would be very worthwhile to show to almost any auditing or
similar class as a warning to those about to enter the accounting
profession.

Denny Beresford

Jensen Comment on Some Things You Can Learn
from the Video
David Meyers became a convicted felon largely because he did not say no when
his supervisor (Scott Sullivan, CFO) asked him to commit illegal and
fraudulent accounting entries that he, Meyers, knew were wrong.
Interestingly, Andersen actually lost the audit midstream to KPMG, but KPMG
hired the same same audit team that had been working on the audit while
employed by Andersen. David Myers still feels great guilt over how much he
hurt investors. The implication is that these auditors were careless in a
very sloppy audit but were duped by Worldcom executives rather than be an
actual part of the fraud. In my opinion, however, that the carelessness was
beyond the pale --- this was really, really, really bad auditing and
accounting.

At the time he did wrong, he rationalized that
he was doing good by shielding Worldcom from bankruptcy and protecting
employees, shareholders, and creditors. However, what he and other criminals at
Worldcom did was eventually make matters worse. He did not anticipate this,
however, when he was covering up the accounting fraud. He could've spent 65
years in prison, but eventually only served ten months in prison because he
cooperated in convicting his bosses. In fact, all he did after the fact is tell
the truth to prosecutors. His CEO, Bernard Ebbers, got 25 years and is still in
prison.

The audit team while with Andersen and KPMG
relied too much on analytical review and too little on substantive testing and
did not detect basic accounting errors from Auditing 101 (largely regarding
capitalization of over $1 billion expenses that under any reasonable test should
have been expensed).

Meyers feels that if
Sarbanes-Oxley had been in place it may have deterred the fraud. It also
would've greatly increased the audit revenues so that Andersen/KPMG could've
done a better job.

To Meyers' credit, he did not exercise his $17
million in stock options because he felt that he should not personally benefit
from the fraud that he was a part of while it was taking place. However, he did
participate in the fraud to keep his job (and salary). He also felt compelled to
follow orders the CFO that he knew was wrong.

The hero is detecting the fraud was Worldcom's internal
auditor Cynthia Cooper who subsequently wrote the book:Extraordinary Circumstances: The Journey of a Corporate Whistleblower
(Hoboken, New Jersey: John Wiley & Sons, Inc.. ISBN 978-0-470-12429)
http://www.amazon.com/gp/reader/0470124296/ref=sib_dp_pt#

KPMG Should Be Tougher on Testing, PCAOB Finds The Big Four audit firm was
cited for not ramping up its tests of some clients' assumptions and internal
controls KPMG did not show enough skepticism toward clients
last year, according to the Public Company Accounting Oversight Board, which
cited the Big Four accounting firm for deficiencies related to audits it
performed on nine companies. The deficiencies were detailed in an inspection
report released this week by the PCAOB that covered KPMG's 2008 audit season.
The shortcomings focused mostly on a lack of proper evidence provided by KPMG to
support its audit opinions on pension plans and securities valuations. But in
some instances, the firm was cited for weak testing of internal controls over
financial reporting and the application of generally accepted accounting
principles.
Marie Leone, CFO.com, June 19, 2009 ---
http://www.cfo.com/article.cfm/13888653/c_2984368/?f=archives

In one
instance, the audit lacked evidence about whether the pension plans
contained subprime assets. In another case, the PCAOB noted, the audit
firm didn't collect enough supporting material to gain an understanding
of how the trustee gauged the fair values of the assets when no quoted
market prices were available.

The PCAOB,
which inspects the largest public accounting firms on an annual basis,
also found that three other KPMG audits were shy an appropriate amount
of internal controls testing related to loan-loss allowances, securities
valuations, and financing receivables.

In one audit,
KPMG accepted its client's data on non-performing loans without
determining whether the information was "supportable and appropriate."
In another case, KPMG "failed to perform sufficient audit procedures"
with regard to the valuation of hard-to-price financial instruments.

In still
another case, the PCAOB found that KPMG "failed to identify" that a
client's revised accounting of an outsourcing deal was not in compliance
with GAAP because some of the deferred costs failed to meet the
definition of an asset - and the costs did not represent a probably
future economic benefit for the client.

KPMG’s “Unusual Twist”
While KPMG's strategy isn't uncommon among corporations with lots of units in
different states, the accounting firm offered an unusual twist: Under KPMG's
direction, WorldCom treated "foresight of top management" as an intangible asset
akin to patents or trademarks.
See http://www.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud

Punch Line
This "foresight of top management" led to a 25-year prison sentence for
Worldcom's CEO, five years for the CFO (which in his case was much to lenient)
and one year plus a day for the controller (who ended up having to be in prison
for only ten months.) Yes all that reported goodwill in the balance sheet of
Worldcom was an unusual twist.

Integrity is a cornerstone
of our culture and we continue to make great progress in our effort to
build a model ethics and compliance program. This means fostering
awareness, trust, and personal responsibility at every level of the
firm. This year, we issued our first ever ethics and compliance progress
report and guidebook. This report,
Ethics and Compliance Report 2007: It Starts with You,
highlights initiatives that we have in place to
support our values-based compliance culture, and features real-life
stories of some of KPMG's partners and employees who faced ethical
challenges and how they handled them. We responded to heightened
interest in ethics education and input from your fellow academics and
created our KPMG Ethical Compass—A
Toolkit for Integrity in Business, a three-module package of
classroom materialsto help you present ethics-related topics to your
students. An Open Letter From Tim Flynn, Chairman and CEO, KPMG LLP This was part of an email message that I assume was sent to
the academy of accountants.

"PCAOB Rips E&Y on Revenue Recognition: Two of Ernst & Young's
clients had to restate financial results after the accounting-firm overseer
found departures from GAAP," by Sarah Johnson, CFO.com, May 27, 2009 ---
http://www.cfo.com/article.cfm/13725058/c_13725042

Ernst & Young failed to note when two clients
strayed from revenue-recognition rules, according to the latest inspection
report on the Big Four firm by the Public Company Accounting Oversight
Board. Consequently, the regulator's sixth annual inspection of E&Y resulted
in those clients having to restate their previously issued financial
statements to make up for the departure from U.S. generally accepted
accounting principles.

These companies — whose identity the PCAOB keeps
confidential — had "failed" to fully follow FAS 48, Revenue Recognition When
Right of Return Exists. The rule calls on companies to, at the time of sale,
make reasonable estimates of how many products that customers will return as
a factor in deciding when revenue can be recorded.

Further criticizing the audit firm for its work on
a third client, the PCAOB claims E&Y didn't test the issuer's VSOE, or
vendor-specific objective evidence, which is used to figure out whether the
amount of revenue recognized for individual parts of a technology contract
was reasonable.

The PCAOB noted the revenue recognition audit
deficiencies mentioned here, as well as several others at eight of E&Y's
clients after reviewing the firm's work between April and December of last
year. The deficiencies were linked to the firm's national office in New York
and 22 of its 85 U.S. offices. These errors were significant enough for the
oversight board to conclude the firm "had not obtained sufficient competent
evidential matter to support its opinion on the issuer's financial
statements or internal control over financial reporting."

The PCAOB also criticized E&Y for not fully
exploring a client's revenue contracts to see how their terms could affect
the issuer's revenue recognition, for not doing enough work to assess the
valuation of another issuer's securities, and for relying on information an
issuer had deemed unreliable for estimating an income-tax valuation
allowance.

To be sure, eight clients may not be many in terms
of the number of audits looked at by the oversight board, or when taking
into account that E&Y audits more than 2,300 publicly traded companies. The
PCAOB, however, doesn't specify how many audits it reviewed and discourages
readers of its inspection reports from drawing conclusion on a firm's
performance based solely on the number of the reported deficiencies
mentioned. "Board inspection reports are not intended to serve as balanced
report cards or overall rating tools," the PCAOB notes.

For its part, E&Y, in all but two of the
deficiencies cited, revisited its work and made changes. "Although we do not
always agree with the characterization in the report ... in some instances
we did agree to perform certain additional procedures or improve aspects of
our audit documentation," E&Y wrote in a letter dated May 4, that was
included in the PCAOB report.

In a recent
poston business combinations accounting that is
related toSAB
112, I criticized the FASB for creating yet
another loophole in business combinations accounting that make M&A
transactions more attractive than they really should be. To recap, I
described how JP Morgan wrote down toxic loans acquired from WaMu so that,
going forward, JP Morgan had a built-in stream of future earnings at very
high interest rates.

First, a Mea Culpa

I was feeling pretty satisfied with myself until
reader
Michaelinterrupted my reverie with several
interesting and valid comments. With great reluctance, I began to re-think
parts of my screed.

First of all, he found a couple of inaccuracies in
my telling, which should be corrected:

"Tom, I think I'm with you on your conclusion
(i.e. mark all financial assets to fair value (replacement cost?)) but
the area of GAAP causing the inconsistent measurement is not FAS 141(R).
FAS 141(R) was first effective for transactions that closed on or after
1/1/09 for calendar year companies. JPMorgan was subject to FAS 141 (no
R) for this transaction and disclosed as such. However, you may be aware
that even under FAS 141, certain loans were required to be accounted for
at fair value, notwithstanding the SAB [Topic 2A-(5)]...those loans that
were purchased at a significant discount are subject to the guidance in
SOP 03-3, which requires a fair value measurement [at the acquisition
date] for such loans. Given the purely awful composition of WaMu's
portfolio, it is not surprising that half their loans fell into that
guidance. I think most of the focus should be on the
criminal allowance put up by WaMu pre-transaction...$2 billion on $240
billion in loans at 3/31/08, $8 billion on $240 at 6/30/08. Yikes."
[italics and bolding supplied]

That's a really interesting last sentence,
especially coming from an auditor, and I'm betting that even the PCAOB will
not want to go near that one. As important as that may be, it's a digression
from the mea culpa I now proffer to all who read that post: I
overlooked the fact that SOP 03-3 would be applicable, because I mistakenly
thought the acquisition of WaMu was accounted for under FAS 141(R).

Michael's comment and my mea culpa
notwithstanding, the fact remains that henceforth, FAS 141(R) has taken over
for SOP 03-3 in the earnings management toolbox when it comes to making sure
that a business combination transaction will be accretive to future
earnings. (Note: that doesn't mean that SOP 03-3 has become obsolete. Loan
acquisitions that are not part of a business combination are also within its
scope.)

Michael also responded to my suggestion that the
offending provision of FAS 141(R) should be suspended until loans are fair
valued. He pointed out that should that day ever come, the invitation for
earnings management of which I spoke doesn't completely go away:

" … [L]et's assume that all financial
instruments were remeasured each period at fair value. While there will
be timing differences with loans that are measured at fair value at
acquisition, net income over the life of the same loans will be the
same...if JPMorgan had to continue to remark the loans, they'd still
recognize that accretion into earnings if the loans ultimately perform.
I understand your generally well founded skepticism, but I think this is
one of the less offensive areas of FAS 141R.

Michael is right (again). I could live with an
outcome whereby unbiased fair value measurements will provide a
stream of accounting earnings to an acquiree. But, I am indeed more than a
little skeptical that two versions of fair value will emerge from FAS
141(R)—if they haven't already from other games that executives will play
with earnings. The WaMu's will still have strong incentives to overstate
market value, and even Michael implies that auditors are not likely to stand
in their way. The JP Morgans of the world have incentives to understate the
same fair values.

Enter SAB 112

That's where SAB 112 comes into the discussion.
Among other ministerial changes, it deleted Topic 2A-(5) of the SAB
codification, which I described in the earlier post and became unnecessary
after FAS 141(R) instituted the fair value requirement for acquired loans.
The crux of this post is this: if the SEC thought that manipulation of loan
loss reserves during a business combination merited an anti-abuse rule, then
more than ministerial adaptations were called for. How can the SEC be so
naïve as to think that fair value will fix the problem of loan value
manipulation? Instead of merely deleting Topic 2A-(5), they should have
re-written it to put the brakes on what will surely become a new recipe for
chicken salad. It would have been really simple for the SEC to make the
following rule:

Irrespective of pre- and post-acquisition
bases of measurement, the new carrying amount of every asset recognized
may be no less at the date of acquisition than the carrying amount
recognized by the acquiree; similarly, the fair value of liabilities
assumed may be no greater than amounts recognized by acquirees.

I know that my suggestion may sound unprinicpled
and draconian to some (and I would be prepared to allow for some
exceptions), but the reality is that no set of business combination
accounting rules will be perfectly 'efficient.' For any accounting rule, it
is inevitable that some value-creating transactions will be discouraged, and
some value-destroying transactions will occur because the accounting result
is too sweet to resist. The key for regulators is to strike an appropriate
balance based on broadly acceptable objectives for financial reporting.

In regard to business combinations, there have been
no such objectives ever before. It is clear that the rules have been
completely out of whack since the inception of GAAP in the 1930s. As for the
last few decades, the evidence is crystal clear that our economy has been
administered a nearly lethal dose of value-destroying business combinations
to juice executive compensation while killing share prices and wreaking
havoc among rank and file employees. That's why I believe it is time to
trying something more radical: an acquiror should not be able to create
a stream of reported earnings by writedowns to assets or increases to
liabilities. Therefore, post acquisition writedowns of assets and
write-ups of liabilities would be charged against the post-combination
earnings of the acquiror.

Let's see if the 'new SEC' is up to the task. We'll
know they're doing it right if the EU and IASB have conniptions over it.

The John Stewart & Jim Cramer battle made numerous
rounds and yet the question still remains- should the financial media be
held accountable for failing to warn citizens of the economic/financial
downturn?

Introduction (Via Fora.TV)

Should financial media be held accountable for
their failure to have warned the public of the current economic downturn?
What steps are being taken to avoid this happening in the future?

A panel of leading financial reporters assess the
global crisis and discuss the ‘perfect storm’ of events that led to it.
Aspiring journalists will hear how to avoid the perils and pitfalls of the
profession, and media observers can decide for themselves if the media is to
blame.

About the Speaker (Via Fora.TV)

Liz Claman - Liz Claman joined FOX Business Network
(FBN) as an anchor in October 2007. Her debut included an exclusive
interview with Berkshire Hathaway CEO and legendary investor Warren Buffett.

Alan Murray - Alan Murray is a Deputy Managing
Editor of The Wall Street Journal and Executive Editor for the Journal
Online. He also has editorial responsibility for Wall Street Journal
television, books, conferences, and the MarketWatch web site. Mr. Murray
spent a decade as the Journal’s Washington bureau chief.

Jeff Bercovici - Jeff Bercovici joined Conde Nast
Portfolio from Radar magazine, where he was part of the relaunch team for
both the online and print editions.

Fiery Debate Over Fair Value Accounting
"The Fair-Value Deadbeat Debate Returns: On hiatus while other fair-value
questions were debated, the hotly-contested issue of why companies can book a
gain when their credit rating sinks has returned to center stage," by
Marie Leone, CFO.com, June 29, 2009 ---
http://www.cfo.com/article.cfm/13932186/c_2984368/?f=archives

A new discussion paper released last week by the
staff of the International Accounting Standards Board has revived an old,
but still fiery fair-value controversy.

At issue: the role of credit risk in measuring the
fair value of a liability. According to the paper's opening statement: the
topic has "arguably ... generated more comment and controversy than any
other aspect of fair value measurement."

At the heated core of the dispute is the question
of why accounting rules allow companies to book a gain when their credit
rating actually sinks. The accounting convention, which opponents contend is
counterintuitive if not ridiculous, has prompted "a visceral response to an
intellectual issue," says Wayne Upton, the IASB project principal who
authored the discussion paper.

For all the hubbub around it, the rule is rather
simple: When a company chooses to use the fair value method of accounting,
it must mark its liabilities as well as its assets to market. As a company's
credit rating goes down, so does the price of its debt, which therefore must
be re-measured by marking the liability to market. The difference between
the debt's carrying value and its so-called fair value is then recorded as a
debit to liabilities, and a credit to income.

Consider an oversimplified example to clarify the
accounting treatment. A company records a $100 liability for a bond it has
issued. Overnight, the company's credit rating drops from A to BB. That drop
causes the price of the bond trading in the market to decrease from $100 to
$90. The $10 difference, under current accounting rules, is recorded as a
$10 debit to liabilities on the balance sheet and a $10 credit to income on
the income statement.

As the company's credit rating and the price of the
bond rise — to, say, $100 again — the accounting is reversed. Income takes a
$10 hit, while the liability account is credited.

That accounting oddity has been a lingering problem
since 2000, when the Financial Accounting Standards Board introduced Concept
Statement 7, which includes a general theory on credit standing and
measuring liabilities. The notion was hotly debated again in 2005, when IASB
revised IAS 39, its measurement rule for financial instruments and in 2006
when FASB issued FAS 157, its fair-value measurement standard.

Addison Everett, the practice leader for global
capital markets at PricewaterhouseCoopers, notes that the debate cooled down
over the last 18 months as the liquidity crisis bubbled up. The crisis
spotlighted more politically charged fair-value topics such as asset
valuation in illiquid markets, classification of financial assets, asset
impairment, and financial disclosures, he says.

But the credit risk quandary is back, demanding the
attention of investors, regulators, and lawmakers who were carefully
watching ailing financial institutions as they posted their first-quarter
earnings results. As financial results were disclosed this year, it became
clear that IAS 39 and FAS 157 were being used to boost income as banks and
insurance companies became less creditworthy. For example, in the first
quarter, Citigroup benefited from its credit rating downgrade by posting a
$30 million gain on its own bond debt.

A Credit Suisse report looking back to last year,
flagged a similar trend. The bank examined the first-quarter 2008 10-Qs of
the 380 members of the S&P 500 with either November or December year-end
closes, the first big companies to adopt FAS 157. For the 25 companies with
the biggest liabilities on their balance sheets measured at fair value,
widening credit spreads-an indication of a lack of creditworthiness-spawned
first-quarter earnings gains ranging from $11 million to $3.6 billion.

Those keen on keeping the rules intact and allowing
companies to book a gain when credit ratings worsen give several reasons for
their stance. Most are laid out neatly in the IASB discussion paper.
Consistency is one argument. "Accountants accept that the initial
measurement of a liability incurred in an exchange for cash includes the
effect of the borrower's credit risk," according to the paper. There's "no
reason why subsequent current measurements should exclude changes."

There's a practical problem with that argument,
however. Not all liabilities are financial in nature. Non-financial
liabilities, such as those tied to plant closings (asset removal), product
warranties, pensions, insurance claims, and obl igations linked to sales
contracts, are not as easily marked to market as a clear-cut borrowing.
Often non-financial liabilities represent a transaction with an individual
counterparty that has already placed a price on the chance of not being
repaid. For many of those liabilities, "accounting standards differ in their
treatment of credit risk," notes the paper.

One cure is to use a risk-free discount rate for
all liabilities in order to apply a consistent measurement approach. But
applying a blanket discount rate to the initial measure of debt leaves
accountants with the problem of what to do with the debit. That is, for
financial liabilities, should the debit be treated as a borrowing penalty
and therefore as a charge against earnings? Or should the debit be
subtracted from shareholder's equity and amortized into earnings over the
life of the debt? For non-financial debt, should the debit be the recognized
warranty or plant-closing expense?

This issue arose at the time of FASB's (brilliant)
special report on using cash flow information in 1996. Between the time of
the issue of the special report and the conceptual statement emanating from
it, the position had changed. In the report, from memory, the position was
the actuarially pure one in which both sides of the balance sheet were
discounted at the same, risk free rate.

When the CS was issued in draft it had changed to
the, arguably, actuarially invalid position that the balance sheet was
discounted at different rates - assets would be at the risk free rate and
liabilities at a rate reflecting the credit risk of the accounting entity.

At the time I found this to be bizarre. I have
slowly changed my mind over the last decade. The apparent maintenance of
actuarial purity across the balance sheet is actually an illusion. To apply
the risk free rate to assets necessitates a significant degree of
mathematical calculation prior to its application (see IAS 36 para 30). No
such computation is necessary for liabilities.

Ultimately, it is best to look at the practical
effects of which two are illustrative.

Firstly, the value of a liability should be the
same as the value of the asset in the counter-party's records, being the
creditor. The creditor would apply a process which would compute the credit
risk premium from a probability analysis, being the spread, and then apply
the risk free rate. All that is happening in debtor's accounting records is
the mirror of this process. Intuitively this must be correct.

Second, I do recall many years ago being sent a
case by a man named William (?) Hackney, a lawyer from Pittsburgh I think
who wrote academic articles about the determination of corporate solvency
and GAAP. (I have lost touch with him, does anybody know him?). The case
involved TWA and its solvency. One side argued that the correct value of its
liabilities for solvency purposes was its market value. Its debt traded at
50 cents in the dollar so its liabilities were 50% of its face value.

Dr Liability Cr Equity

with 50% of the value.

The other contestant in the matter claimed the
liability should be face value.

I have lost my copy of the case but I think the
discounter won. This makes a kind of perverse sense. One of the essential
characteristics of a liability is that it results in an outflow of funds. A
company with an asset costing $100 fully funded by a liability where that
asset fetches only $25 will only cause an outflow of funds to $25. That must
be the value of the liability therefore.

Where this becomes perverse is that a company is
never insolvent because as it falls into the abyss its liabilities erode in
the same proportion to the erosion of its assets. In insolvency law this
becomes extremely problematic as insolvency is the determinant of civil or
criminal sanction or penalty.

The FASB Probably Won't Care for this
Teaching CaseBut it provides good input for
student debates on fair value accountingIn fairness, the FASB contends that the what bankers claim is a major change
in FAS 157 really is a cosmetic change that wasn't truly needed but is no big
deal if it makes bankers happy. If the banks really wanted to bypass Level 1 and
2 fair value estimation, they could've moved to Level 3 all along without the
rule change. Whatever the reasons or excuses, banks with toxic loan portfolios
can now report higher earnings that have little to do with higher cash flows
(unless the cash is rolled in from TARP bailout loans and gifts is reduced
because gullible investors are relying on phony bank earnings reports). Sadly,
the European Union is now bringing similar pressures to bear on IFRS fair value
accounting.

Personally, I thought the blaming fair value accounting standards by Bill
Isaac and his billionaire friends (Warren Buffet and Steve Forbes) for the bank
failures was a pile of crap ---
http://www.trinity.edu/rjensen/2008Bailout.htm#FairValue
The banks failed because of dysfunctional mortgage lending policies that
encouraged fraud, dysfunctional performance compensation schemes that encouraged
bankers to cheat shareholders, and too much reliance on David Li's flawed
Gaussian copula function ---
http://www.trinity.edu/rjensen/2008Bailout.htm

SUMMARY: This
article reports on a WSJ investigation into lobbying of, and contributions
to, members of the House Financial Services subcommittee. "Earlier this
year...thirty-one financial firms and trade groups formed a coalition and
spent $27.6 million in the first quarter lobbying Washington about [changing
the FASB's fair value] rule and other issues, according to a Wall Street
Journal analysis of public filings. They also directed campaign
contributions totaling $286,000 to legislators on a key committee, many of
whom pushed for the rule change, the filings indicate." The FASB ultimately
responded to pressure by issuing a staff position on April 9, 2009 allowing
financial institutions to use greater judgment in determining market values
when markets show evidence of illiquidity and signs of being disorderly than
was originally included in Statement 157. "The American Bankers Association
(ABA)...acknowledges that it exerted pressure to change the rules. The ABA
was the biggest donor to the campaign funds of committee members in the
weeks before the hearing. It gave a total of $74,500 to 33 members of the
committee in the first quarter, according to the Journal analysis of public
filings. An ABA spokesman says that is its normal level of support for
lawmakers, and that the initiative was part of a broader effort to change
accounting rules....We worked that hearing," says ABA President Edward
Yingling. "We told people that the hearing should be used to talk about the
big problems with 'mark to market,' and you had 20 straight members of
Congress, one after another, turn to FASB and say, 'Fix it.'"

CLASSROOM APPLICATION: This
article shows the political nature of the accounting standards setting
process. It also shows how the press can obtain information and conduct
analyses to keep interested individuals aware of the process. In this case,
the interested individuals include investor groups who feel that the
accounting changes watered down the fair value reporting standards.

QUESTIONS:
1. (Introductory)
In general, what are the requirements established in FASB Statement No. 157,
Fair Value Measurements? Hint: you may access this FASB document on their
web site at
http://www.fasb.org/st/

2. (Introductory)
What changes were implemented with FASB Staff Position (FSP) 157-4? Again,
you may access the document at
http://www.fasb.org/st/

3. (Introductory)
In general, what is the usual process for establishing authoritative
accounting literature?

4. (Advanced)
How did the U.S. political process influence this change in accounting
requirements under fair value reporting? What are the concerns with the
usual process for establishing accounting standards?

5. (Advanced)
As reported in this article, who is displeased with this change in financial
reporting requirements? Are their concerns limited to whether the
appropriate accounting requirements have been set?

6. (Advanced)
What do you think about having our elected officials in Congress, influence
the process of establishing accounting standards?

Not long after the bottom fell out of the market
for mortgage securities last fall, a group of financial firms took aim at an
accounting rule that forced them to report billions of dollars of losses on
those assets.

Marshalling a multimillion-dollar lobbying
campaign, these firms persuaded key members of Congress to pressure the
accounting industry to change the rule in April. The payoff is likely to be
fatter bottom lines in the second quarter.

The accounting issue lies at the heart of the
financial crisis: Are the hardest-to-value securities worth no more than
what the market is willing to pay, or did the market grow too dysfunctional
to properly set values?

The rule change angered some investor advocates.
"This is political interference on a major issue, and it raises questions
about whether accounting standards going forward will have the quality and
integrity that the market needs," says Patrick Finnegan, director of
financial-reporting policy for CFA Institute Centre for Financial Market
Integrity, an investor trade group.

Backers of the change say it was necessary because
existing accounting rules never contemplated the kind of market turmoil that
unfolded last year.

The rules had required banks, securities firms and
insurers to use market prices to help assign values to mortgage securities
and other assets that don't trade on exchanges -- to "mark to market." But
when markets went haywire last fall, financial firms complained that the
rules forced them to slash the value of many assets based on fire-sale
prices. That contributed to big losses that depleted their capital and left
several of the nation's largest firms on the brink of failure.

Earlier this year, financial-services organizations
put their lobbyists on the case. Thirty-one financial firms and trade groups
formed a coalition and spent $27.6 million in the first quarter lobbying
Washington about the rule and other issues, according to a Wall Street
Journal analysis of public filings. They also directed campaign
contributions totaling $286,000 to legislators on a key committee, many of
whom pushed for the rule change, the filings indicate.

Rep. Paul Kanjorski, a Pennsylvania Democrat who
heads the House Financial Services subcommittee that pressed for the
accounting change, received $18,500 from coalition members in the first
quarter, the second-highest total among committee members, according to
Federal Election Commission records. Over the past two years, Mr. Kanjorski
received $704,000 in contributions from banking and insurance firms, the
third-highest total among members of Congress, according to the FEC and the
Center for Responsive Politics.

A spokeswoman says Rep. Kanjorski believes the
accounting industry's rule-making body, the Financial Accounting Standards
Board, or FASB, made the right move since neither mark-to-market critics nor
advocates are "entirely pleased with the outcome." She says campaign
contributions didn't factor into the congressman's thinking.

Congressional Attention During a March 12 hearing
before the House subcommittee, FASB came under intense pressure from
committee members. "If the regulators and standard setters do not act now to
improve the standards, then the Congress will have no other option than to
act itself," Rep. Kanjorski said in his opening remarks.

"We want you to act," Rep. Kanjorski told Robert
Herz, FASB's chief. Mr. Herz waffled about how quickly the standards board
could act. Rep. Kanjorski leaned over the dais. "You do understand the
message that we're sending?" he said.

"Yes," Mr. Herz replied. "I absolutely do, sir."

FASB made speedy revisions to its rules. In an
interview, Mr. Herz said FASB merely accelerated the matter on its agenda,
and tried to be responsive to input from investors and financial-services
firms.

The change helped turn around investor sentiment on
banks. Financial firms had the option of reflecting the accounting change in
their first-quarter results; they will be required to do so in the second
quarter. Wells Fargo & Co. said the change increased its capital by $4.4
billion in the first quarter. Citigroup Inc. said the change added $413
million to first-quarter earnings. The Federal Home Loan Bank of Boston said
the shift boosted its first-quarter earnings by $349 million.

Robert Willens, a tax and accounting analyst,
estimates that the changes will increase bank earnings in the second quarter
by an average of 7%.

Building Pressure The American Bankers Association,
a trade group, acknowledges that it exerted pressure to change the rules.
The ABA was the biggest donor to the campaign funds of committee members in
the weeks before the hearing. It gave a total of $74,500 to 33 members of
the committee in the first quarter, according to the Journal analysis of
public filings. An ABA spokesman says that is its normal level of support
for lawmakers, and that the initiative was part of a broader effort to
change accounting rules.

"We worked that hearing," says ABA President Edward
Yingling. "We told people that the hearing should be used to talk about the
big problems with 'mark to market,' and you had 20 straight members of
Congress, one after another, turn to FASB and say, 'Fix it.'"

The banking industry's victory stands in contrast
to at least one defeat it has been dealt in recent weeks, on new credit-card
legislation.

Changing Environment Mark-to-market accounting has
been around for decades. Many banks were content with the rules when the
markets were going up. But the rules became a big problem in late 2007. As
markets turned down, FASB clarified the rules and established how certain
financial instruments, including mortgage securities, should be valued.

Now we see real reporting instead of the puff piece
on Bloomberg yesterday:

In a move that confirmed the suspicions of many
analysts, the agency called off plans to start a $1 billion (read
that $1 trillion) pilot program this month that was
intended to help banks clean up their balance sheets and eventually sell off
hundreds of billions of dollars worth of troubled mortgages and other loans.

Many banks have refused to sell their loans, in
part because doing so would force them to mark down the value of those loans
and book big losses. Even though the government was prepared to prop up
prices by offering cheap financing to investors, the prices that banks were
demanding have remained far higher than the prices that investors were
willing to pay.

Translation:

The banks are still carrying these "assets" at
well-above their actual market value. This means their balance sheets are
showing them to be healthier than they really are.

The Government, which claimed it was going to
"drain the swamp" and get the market moving again, tried everything short of
the barrel of an M-16 in the mouth of people like Blankfein and Pandit, but
couldn't get them to sell.

But rather than force the recognition of market
prices on the balance sheets, which would force these banks to either sell
or be FDIC'd (incidentally, the only correct pair of options the banks
should have) the government instead is allowing the banks to continue to lie
about the market value of these "assets" and carry them above what the
market will pay - that is, they are allowing the continuing intentional
distortion of so-called "book value", reserve ratios and soundness.

Of course this isn't how the government banking
cartel (the same so-called "regulators" that allowed and even encouraged
book-cooking when it came to reserves and deposits) sees it:

F.D.I.C. officials portrayed the change as a sign
that banks were returning to health on their own.

Baloney. If the banks were returning to health on
their own they wouldn't care if the market price was recognized on their
balance sheets.

The FDIC is lying.

But some analysts said the banks’ reluctance to
clean up their balance sheets meant they were merely postponing their day of
reckoning. Indeed, some analysts said government policies had made it easier
for banks to gloss over their bad loans.

"Gloss over" is another fancy word for fraudulent
accounting practices, all made "legitimate" by our government.

No one knows exactly how many losses are buried in
the troubled mortgages on banks’ books, but some analysts estimate that the
unrecognized losses total more than $1 trillion. Under accounting rules,
banks do not have to write down the value of most mortgages unless they sell
them or they fall delinquent.

And, as Wells Fargo did last year, they can change
the rules on when something is "delinquent"! That is, it can be 30 days
behind today, 60 tomorrow, and three years next week. That's all ok,
according to our so-called "regulators."

The Federal Reserve also is pumping hundreds of
billions of dollars into mortgage-backed securities, and into other kinds of
consumer and business lending. Starting next month, the Fed plans to offer
cheap financing for investors who want to buy “legacy” securities backed by
mortgages on commercial real estate.

Of course this simply means that the Federal
Reserve (that is, you) will eat the loss.

Heh, its only your (tax) money, right?

No banker left behind, no fraud to be punished
(ever) indeed.

PS: The deception cannot continue beyond where the
cash flow ceases. In the end you can't pay your electric bill with phony
capitalized interest that you will NEVER collect! That day, unfortunately,
will likely coincide with the collapse of the FDIC, at which point every
nickel you have in any bank anywhere will be GONE, courtesy of our
government continuing to enable, allow and even participate in raw fraud.
Its been going on now for more than two years folks, and the cops have all
been bribed!

Sydney Finkelstein, the Steven Roth professor of management at the Tuck School
of Business at Dartmouth College, also pointed out that Bank of America booked a
$2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired
last quarter to prices that were higher than Merrill kept them. “Although
perfectly legal, this move is also perfectly delusional, because some day soon
these assets will be written down to their fair value, and it won’t be pretty,”
he said
"Bank Profits Appear Out of Thin Air ," by Andrew Ross Sorkin, The New
York Times, April 20, 2009 ---
http://www.nytimes.com/2009/04/21/business/21sorkin.html?_r=1&dbk

This is starting to feel like amateur hour for aspiring magicians.

Another day, another attempt by a Wall Street bank to pull a bunny out of the
hat, showing off an earnings report that it hopes will elicit oohs and aahs from
the market. Goldman Sachs, JPMorgan Chase, Citigroup and, on Monday, Bank of
America all tried to wow their audiences with what appeared to be — presto! —
better-than-expected numbers.

But in each case, investors spotted the attempts at sleight of hand, and didn’t
buy it for a second.

With Goldman Sachs, the disappearing month of December didn’t quite disappear
(it changed its reporting calendar, effectively erasing the impact of a $1.5
billion loss that month); JPMorgan Chase reported a dazzling profit partly
because the price of its bonds dropped (theoretically, they could retire them
and buy them back at a cheaper price; that’s sort of like saying you’re richer
because the value of your home has dropped); Citigroup pulled the same trick.

Bank of America sold its shares in China Construction Bank to book a big
one-time profit, but Ken Lewis heralded the results as “a testament to the value
and breadth of the franchise.”

Sydney Finkelstein, the Steven Roth professor of management at the Tuck School
of Business at Dartmouth College, also pointed out that Bank of America booked a
$2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired
last quarter to prices that were higher than Merrill kept them.

Although perfectly legal, this move is also perfectly delusional, because
some day soon these assets will be written down to their fair value, and it
won’t be pretty,” he said.

I agree and have been amazed about the “supposed”
problems with FAS 157 which were trumpeted by those who had either not read
it … or were convinced that those they were filling full of propaganda would
never read it. (Somebody ask Steve Forbes or Larry Kudlow!)

However, I have heard that the issue was not the
Banks or the FASB’s original text, but the PCAOB’s hammering of any Audit
Firm which allowed Level 3 to be used. This would be concerning if the PCAOB
was not following the rules put forth by the FASB. Sort of a world of SRO
dysfunction, if true! Have you heard anything about this? (It may be only
criticism of inappropriate use of Level 3)

Whether the PCAOB and the FASB are at odds, or if
the Banks still have not marked to market, either aberrant reality is a
problem.

To your knowledge, do any of the big banks use
second tier audit firms (or lower) who perhaps do not interact as frequently
with the PCAOB? (I know it sound crazy but since Madoff you must always
ask.)

Finally, how does the PCAOB stay away from
testifying in front of Kanjorski’s Congressional Committee?

The FASB has published
Financial Accounting Statements No. 166, Accounting for Transfers of
Financial Assets, and No. 167, Amendments to FASB Interpretation No. 46(R),
which change the way entities account for securitizations and
special-purpose entities.

The new standards
will impact financial institution balance sheets beginning in 2010. The
impact of both new standards has been taken into account by regulators in
the recent “stress tests.”

These
projects were initiated at the request of investors, the SEC, and The
President’s Working Group on Financial Markets. Copies of the new standards
are available at the
FASB’s website, along with a concise
briefing document.

Statement 166 is a
revision to Statement No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, and will require more
information about transfers of financial assets, including securitization
transactions, and where companies have continuing exposure to the risks
related to transferred financial assets. It eliminates the concept of a
“qualifying special-purpose entity,” changes the requirements for
derecognizing financial assets, and requires additional disclosures.

Statement 167 is a
revision to FASB Interpretation No. 46(R), Consolidation of Variable
Interest Entities, and changes how a company determines when an entity that
is insufficiently capitalized or is not controlled through voting (or
similar rights) should be consolidated. The determination of whether a
company is required to consolidate an entity is based on, among other
things, an entity’s purpose and design and a company’s ability to direct the
activities of the entity that most significantly impact the entity’s
economic performance.

Robert Herz,
chairman of the FASB, said:

“These changes were
proposed and considered to improve existing standards and to address
concerns about companies who were stretching the use of off-balance sheet
entities to the detriment of investors. The new standards eliminate existing
exceptions, strengthen the standards relating to securitizations and
special-purpose entities, and enhance disclosure requirements. They’ll
provide better transparency for investors about a company’s activities and
risks in these areas.”

Both new standards
will require a number of new disclosures. Statement 167 will require a
company to provide additional disclosures about its involvement with
variable interest entities and any significant changes in risk exposure due
to that involvement. A company will be required to disclose how its
involvement with a variable interest entity affects the company’s financial
statements. Statement 166 enhances information reported to users of
financial statements by providing greater transparency about transfers of
financial assets and a company’s continuing involvement in transferred
financial assets.

Both Statements 166
and 167 will be effective at the start of a company’s first fiscal year
beginning after November 15, 2009, or January 1, 2010 for companies
reporting earnings on a calendar-year basis.

The board that sets U.S. accounting standards on
Monday moved to end companies' use of a device that allowed them to park
hundreds of billions of dollars in loans off their balance sheets without
capital cushions and has been blamed for helping stoke banks' losses in the
housing boom.

The change will tighten the use of so-called
"qualifying special purpose entities" by requiring companies to report to
regulators the loans contained in them and to increase their capital
reserves in proportion as a cushion against potential losses.

It was the lack of disclosure and absence of
capital supporting ballooning subprime mortgage loans in these special
entities that aggravated the massive losses sustained by banks, regulators
say.

The change by the Financial Accounting Standards
Board could result in about $900 billion in assets being brought onto the
balance sheets of the nation's 19 largest banks, according to federal
regulators. The information was provided by Citigroup Inc., JPMorgan Chase &
Co. and 17 other institutions during the government's recent "stress tests,"
an analysis designed to determine which banks would need more capital if the
economy worsened.

In its quarterly regulatory filing earlier this
month, Citigroup said the rule change could have "a significant impact" on
its financial statements. Citigroup estimated it would result in the
recognition of $165.8 billion in additional assets, including $90.5 billion
in credit card loans.

JPMorgan estimated in its quarterly filing that the
impact of consolidation of the bank's qualifying special purpose entities
and variable interest entities could be up to $145 billion.

In general, companies transfer assets from balance
sheets to special purpose entities to insulate themselves from risk or to
finance a large project. Under the change by the FASB, many qualifying
special purpose entities will have to be moved back to a company's main
balance sheet.

Outside investors often take interests in those
entities, for example, making an investment in a bank's holdings of mortgage
loans in exchange for payments from borrowers. Under the new standard,
companies must bring back any entity in which they hold an interest that
gives them "control over the most significant activities," according to
FASB. Companies must perform analyses to determine that.

In cases where companies have "continuing
involvements" with off-balance-sheet entities, they will have to provide new
disclosures.

"That's a step in the right direction," said Edward
Ketz, an associate professor of accounting at Pennsylvania State University.
He cited estimates that U.S. banks will need to report up to $1 trillion in
loans due to the rule change.

The FASB said the rule change was intended "to
improve consistency and transparency in financial reporting." The FASB voted
5-0 to adopt it at a public meeting of its board at its headquarters in
Norwalk, Conn. A revised proposal had been opened to a public comment period
that ended in November.

The rule change, which applies both to public and
privately held companies, takes effect for companies' annual reporting
periods starting after Nov. 15.

"It's great to see that they didn't defer it," said
Jack Ciesielski, a Baltimore-based accounting expert who writes a financial
newsletter. Investors finally "will get an idea of how leveraged these
things really are," he said.

The change by FASB cuts in the opposite direction
of its move last month - surrounded by controversy and with some dissension
by board members - giving companies more leeway in valuing assets and
reporting losses. That revision in the so-called "mark-to-market" accounting
rules was expected to help boost battered banks' balance sheets, while the
new rule change likely will result in financial institutions recognizing on
their books billions in high-risk loans that may default.

FASB acted on the mark-to-market rules amid intense
pressure from Congress, which threatened legislation. The board received
hundreds of comment letters opposing the move from mutual funds, accounting
firms and others contending that it would damage honest financial reckoning
by masking the deficiencies and risks lurking within the system.

Question
Would you like to see (AIG) Special Purpose Vehicles pull away from the loading
($25 billion) dock?

In a move aimed at cutting American International
Group's $40 billion debt to the Federal Reserve Bank of New York by $25
billion and setting up two AIG life insurance giants as initial public
offerings, the N.Y. Fed has agreed to a debt-for-equity swap done via
special-purpose vehicles.

Under the agreement announced today, AIG will place
the equity of American International Assurance Company and American Life
Insurance Company in separate SPVs in exchange for preferred and common
shares of the vehicles. The New York Fed will get all the preferred shares
in the two SPVs, amounting to $16 billion in the AIA unit and $9 billion in
the ALICO vehicle.

The New York Fed will be paid a 5 percent dividend
on its shares, which it will get at a fairly hefty discount, until September
2013. For shares that aren't redeemed by that date, the SPVs would start
paying a 9 percent dividend.

The face value of the preferred shares represents a
percentage of the estimated fair-market value of AIA and ALICO. With the
IPOs looming, the parties aren't saying what that value is. But the New York
Fed, which will hold all the preferred shares, will get a majority stake in
the economic value of the companies.

For its part, AIG will hold all the common equity
in the two SPVs and "will benefit from the fair market value of AIA and
ALICO in excess of the value of the preferred interests as the SPVs monetize
their stakes in these companies in the future," AIG said in a release issued
today.

The dates of the closing of the deal and the IPOs
aren't tied to each other. The AIG-New York Fed transaction is expected to
close late in the third quarter of this year. AIA, which has already
launched its IPO process, is expected to start the offering in 2010. While
ALICO hasn't started the process of its offering just yet, it has announced
its attention to do so.

As for the SPVs, they will structured as
limited-liability companies in Delaware. Until they're spun off, AIA and
ALICO will remain wholly owned subsidiaries of AIG, consolidated in the
company's reported financial statements.

"Placing AIA and ALICO into SPVs represents a major
step toward repaying taxpayers and preserving the value of AIA and ALICO,
two terrific life insurance businesses with great futures," said Edward
Liddy, AIG's chairman and chief executive officer said in the release.
"Operating AIA's and ALICO's successful business models in the SPV format
will enhance the value of these franchises as we move forward with our
global restructuring."

Asked why the company chose to structure the
arrangement by means of the much stigmatized method of setting up SPVs, AIG
spokesperson Christina Pretto told CFO that since the vehicles were
on-balance-sheet entities they wouldn't be the target of disapproval.

AIA has one of the biggest books of life insurance
in Asia, and ALICO has a large presence in Japan. While both are profitable,
AIG has found it impossible to achieve its goal of selling the companies-at
least partly because they are so large.

The shift in priorities from earnings per share to
cash was confirmed by a recent survey conducted by the National Association
of Corporate Treasurers, said Edward Liebert, chairman of the association
and treasurer of Rohm & Haas, which was acquired by Dow Chemical in April.
"You can miss your earnings targets and survive, but you can only run out of
cash once," commented Liebert. Treasurers voiced four other top concerns in
the NACT survey: employee benefit funding, primarily pensions; capital
spending; cost control, such as keeping insurance premiums and bank fees
down; and maintaining or gaining access to capital markets.

Tus said he first heard the phrase "fortress
balance sheet" from Jamie Dimon, CEO of JPMorgan Chase & Co. "What it really
means is having a balance sheet that can withstand shocks," Tus explained,
particularly those that may "come out of the woodwork," such as contingent
liabilities and covenant breaches. A fortress balance sheet also gives
companies deal-making flexibility, he added. "Historically, companies that
do the best deals do them at the trough of the market, not at the peak."

This may be a bit of a stretch, but I think that instructors teaching
managerial/cost accounting may set students thinking about the economies of
scale in milk production.

When I grew up on a farm in Iowa, virtually every small town had its own
"creamery" where milk and cream separations from each farm were picked up
locally and bottled in each of the small towns. Virtually all the small town
creameries have been defunct for years.

Here is an attention-grabbing video that could be a great beginning for
study of the production cost function components of dairy farming.

One operation near Chicago provides enough milk for eight million people
--- much more than is needed in the entire city of Chicago.

The methane gas from the manure provides all electric power needed in
each barn.

On the down side, think of the down side of large-scale diaries and
factories in terms of monopoly pricing and the risk of supply disruption
such as when a disease like hoof-and-mouth or mad-cow wipes out the milk
supply for the entire city of Chicago. What is the cost and technology of
preventing this type of disaster from happening? Why are we more vulnerable
to terrorists in our food production and distribution system?

What were the advantages of small town creameries? Why did they all fail?

Brigham Young University (BYU) launched its Open CourseWare (OCW) pilot
with
six Creative Commons licensed courses

Jane Park, June 10th, 2009

It appears that David Wiley’s move to Brigham Young
University has already resulted in progress towards opening the university’s
content. Long-time pioneer and academic of open education, Wiley
reports that
BYU’s Independent Studyhas launched its Open
CourseWare (OCW) pilot with six Creative Commons licensed courses under
CC BY NC-SA.

“The pilot includes three university-level
courses and three high school-level courses (BYU IS offers 250
university-level courses online for credit and another 250 high
school-level courses online for credit). The courses in BYU IS OCW are
content-complete - that is, they are the full courses as delivered
online without the need of additional textbooks or other materials (only
graded assessments have been removed).”

The most interesting thing about this pilot is that
it “is part of a dissertation study to measure the impact of OCW courses on
paying enrollments.” So far, “the results are very positive - 85 of the 3500
people who visited the OCW site last month registered for for-credit
courses… if this pattern remains stable, then BYU IS OCW will be financially
self-sustainable with the ability to add and update a number of new courses
to the collection each year, indefinitely, should they so choose.” Echoing
Wiley, that is an exciting prospect. We look forward to seeing these results
develop, in addition to other inquiries into the sustainability of general
OER initiatives in the future…

You may view, use, and reuse all materials in the Open CourseWare
courses. Please note that Open CourseWare courses do not provide the
opportunity to submit assessments for credit, interact with faculty, or
receive credit or a certificate upon completion. BYU Independent Study
provides these courses as a community service under a Creative Commons
license. The course materials are freely available for you to use, download,
modify and share as long as you do not sell the products you derive from
them. If you alter, transform, or build upon the courses, you may distribute
your work only using licensing terms the same as or similar to the
Creative Commons Atribution-Noncommercial-Share Alike 3.0.

Robert Haugen is one of (if not THE) best-known
figure in the behavioral finance (i.e. "markets are not efficient") camp. He
wrote one of the earliest books on the topic in 1995 (The New Finance) and
runs a quantitative finance shop based on much of his research. In a recent
paper with Nardin Baker of UC-Irvine, he examines the explanatory and
predictive ability of a wide array of observable factors. Here's the
abstract

This article provides conclusive evidence that the U.S. stock market is
highly inefficient. Our results, spanning a 45 year period, indicate
dramatic, consistent, and negative payoffs to measures of risk, positive
payoffs to measures of current profitability, positive payoffs to
measures of cheapness, positive payoffs to momentum in stock return, and
negative payoffs to recent stock performance. Our comprehensive expected
return factor model successfully predicts future return, out of sample,
in each of the forty-five years covered by our study save one.
Stunningly, the ten percent of stocks with highest expected return, in
aggregate, are low risk and highly profitable, with positive trends in
profitability. They are cheap relative to current earnings, cash flow,
sales, and dividends. They have relatively large market capitalization
and positive price momentum over the previous year. The ten percent with
lowest expected return (decile 1) have exactly the opposite profile, and
we find a smooth transition in the profiles as we go from 1 through 10.
We split the whole 45-year time period into five sub-periods, and find
that the relative profiles hold over all periods. Undeniably, the
highest expected return stocks are, collectively, highly attractive; the
lowest expected return stocks are very scary - results fatal to the
efficient market hypothesis. While this evidence is consistent with risk
loving in the cross-section, we also present strong evidence consistent
with risk aversion in the market aggregate's longitudinal behavior.
These behaviors cannot simultaneously exist in an efficient market.

Here are some of the factors that they find
statistically significant:

Price Multiples such as price to cash flow,
sales, book value, and earnings (negative relationship with subsequent
returns

It's worth reading. Haugen is clearly not an ubiased
observer (he does run a shop based on the idea that markets are
inefficient), and there's definitely some serious data mining going on here.
Having said that, it's definitely worth reading. It gives a very good
summary of many of the factors that prior research has found to be
significantly related to subsequent returns. I'll be making the next group
of student in Unknown University's student-managed fund read it.

SUMMARY: The
article assesses the situation of two companies associated with financial
difficulties: Crown Media, 67% owned by Hallmark Cards, and Clear Channel
Outdoor, 89% owned by Clear Channel Media. In the latter case, the entity in
financial difficulty is the owner company. Questions ask students to look at
a quarterly filing by Crown Media, to consider the situation facing
noncontrolling interest shareholders, and to understand the use of earnings
multiplier analysis for pricing a security.

CLASSROOM APPLICATION: The
article is good for introducing the interrelationships between affiliated
entities when covering consolidations. It also covers alternative
calculations of, and analytical use of, a P/E ratio.

QUESTIONS:
1. (Introductory)
Access the Crown Media 10-Q filing for the quarter ended March 31, 2009 at
http://www.sec.gov/Archives/edgar/data/1103837/000110383709000008/mainform5709.htm
Alternatively, click on the live link to Crown Media in the WSJ article,
click on SEC Filings in the left hand column, then choose the 10-Q filing
made on May 7, 2009. Describe the company's financial position and results
of operations.

2. (Advanced)
Crown Media's majority shareholder is Hallmark Cards "which also happens to
be its primary lender to the tune of a billion dollars...." Where is this
debt shown in the balance sheet? How is it described in the footnotes? When
is it coming due?

3. (Advanced)
What has Hallmark Cards proposed to do about the debt owed by Crown Media?
What impact will this transaction have on the minority Crown Shareholders?

4. (Advanced)
Do you think the noncontrolling interest shareholders in Crown Media can do
anything to stop Hallmark Cards from unilaterally implementing whatever
changes it desires? Support your answer.

5. (Introductory)
Refer to the description of Clear Channel Outdoor. How is the company's
share price assessed? In your answer, define the term "price-earnings ratio"
or P/E ratio and explain the two ways in which this is measured.

6. (Advanced)
What does the author mean when he writes that "anyone buying Outdoor stock
should remember that" the existence of a majority shareholder with
significant debt holdings also could pose problems for an investment?

Investing in a company controlled by its primary
lender can be hazardous. Just ask shareholders in Crown Media.

Owner of the Hallmark TV channel, Crown is
67%-owned by Hallmark Cards, which also happens to be its primary lender to
the tune of a billion dollars. With the debt due next year, Hallmark on May
28 proposed swapping about half of its debt for equity, which would
massively dilute the public shareholders. Crown's stock, long supported by
hope that the channel would get scooped up by a big media company, is down
36% since then.

Helping feed outrage among some shareholders was
the fact that the swap proposal comes as the Hallmark Channel was making
inroads with advertisers. Profits were on the horizon.

In this case, of course, the parent is in financial
distress. Hence the significance of Outdoor's contemplation of refinancing
options, which could lead to the loan being repaid. The hope among some
investors is that events conspire to prevent that, forcing the parent into
bankruptcy and putting Outdoor up for auction.

That could bail out shareholders. At $6.36 a share
at Friday's close, Outdoor's enterprise value is roughly 9.8 times projected
2009 earnings before interest, taxes, depreciation and amortization, below
Lamar Advertising's 10.9 times multiple. Using 2010 projections and an
equivalent multiple implies a share price above $10.

But as Crown showed, the interests of a majority
shareholder who doubles as a lender don't necessarily coincide with minority
holders. Anyone buying Outdoor stock should remember that.

It’s foolish not to book and maintain derivatives at fair value since in the
1980s and early 1990s derivatives were becoming the primary means of
off-balance-sheet financing with enormous risks unreported financial risks,
especially interest rate swaps and forward contracts and written options.
Purchased options were less of a problem since risk was capped.

Tom’s argument for maintaining derivatives at fair value even if they are hedges
is not a problem if the hedged items are booked and maintained at fair value
such as when a company enters into a forward contracts to hedge its inventories
of precious metals.

But Tom and I part company when the hedged item is not even booked, which is the
case for the majority of hedging contracts. Accounting tradition for the most
part does not hedge forecasted transactions such as plans to purchase a million
gallons of jet fuel in 18 months or plans to sell $10 million notionals in bonds
three months from now. Hedged items cannot be carried on the balance sheet at
fair value if they are not even booked. And there is good reason why we do not
want purchase contracts and forecasted transactions booked. Reason number 1 is
that we do not want to book executory contracts and forecasted transactions that
are easily broken for zero or at most a nominal penalties relative to the
notionals involved. For example, when Dow Jones contracted to buy newsprint
(paper) from St Regis Paper Company for the next 20 years, some trees to be used
for the paper were not yet planted. If Dow Jones should break the contract, the
penalty damages might be less than one percent of the value of a completed
transaction.

Now suppose Southwest Airlines has a forecasted transaction (not even a
contract) to purchase a million gallons of jet fuel in 18 months. Since it has
cash flow risk, it enters into a derivative contract (usually purchased option
in the case of Southwest) to hedge the unknown fuel price of this forecasted
transaction. FAS 133 and IAS 39 require the booking of the derivative as a cash
flow hedge and maintaining it at fair value. The hedged item is not booked.
Hence, the impact on earnings for changes in the value would be asymmetrical
unless the changes in value of the derivative were “deferred” in OCI as
permitted as “hedge accounting” under FAS 133 and IAS 39.

If there were no “hedge accounting,” Southwest Airlines would be greatly
punished for hedging cash flow by having to report possibly huge variations in
earnings at least quarterly when in fact there is no cash flow risk because of
the hedge. Reported interim earnings would be much more stable if Southwest did
not hedge cash flow risk. But not hedging cash flow risk due to financial
reporting penalties is highly problematic. Economic and accounting hit head on
for no good reason, and this collision was avoided by FAS 133 and IAS 39.

Since the majority of hedging transactions are designed to hedge cash flow or
fair value risk, it makes no sense to me to punish companies for hedging and
encouraging them to instead speculate in forecasted transactions and firm
commitments (unbooked purchase contracts at fixed prices).

The FASB originally, when the FAS 133 project was commenced, wanted to book all
derivative contracts and maintain them at fair value with no alternatives for
hedge accounting. FAS 133 would’ve been about 20 pages long and simple to
implement. But companies that hedge voiced huge and very well-reasoned
objections. The forced FAS 133 and its amending standards to be over 2,000 pages
and hellishly complicated.

But this is one instance where hellish complications are essential in my
viewpoint. We should not make the mistake of tossing out hedge accounting
because the standards are complicated. There are some ways to simplify the
standards, but hedge accounting standards cannot be as simple as most other
standards. The reason is that there are thousands of different types of hedging
contracts, and a simple baby formula for nutrition just will not suffice in the
case of all these types of hedging contracts.

First, I picked my OilCo example because it was
also accounted for as a ‘hedge’ of an anticipated transaction—just like your
Southwest example. I hope you agree that OilCo was speculating. As to
Southwest, you say that Southwest was hedging, but I say they were
speculating. If fuel prices had gone south instead of north, Southwest would
have been at a severe cost disadvantage against the airlines that did not
buy their fuel forward (and they would have become a case study of failure
instead of success). In essence, the forward contracts leveraged their
profits and cash flows. That’s not hedging, it’s speculating.

FAS 133 has been an abject failure, as have all
other ‘special hedge accounting’ solutions that came before it. There will
always be some sort of mismatch between accounting and underlying economics,
but ‘special hedge accounting’ is not the way to mitigate that. You say that
some companies would have been unfairly penalized by entering into hedges
without hedge accounting. I say, with current events providing evidence,
that much more value was destroyed because special hedge accounting provided
cover for inappropriate speculation. To managers, it has been all about
keeping risks off the balance sheet and earnings stable; reducing
(transferring) economic risks that shareholders may be exposed to is an
afterthought. And, besides, most of the time shareholders can reduce their
risks by diversification. As we have seen the hard way, transaction risk
reduction (what FAS 133 requires) can be more than offset by increases in
enterprise risk. On a global scale, FAS 133 (and IAS 39) has done much more
to enable managers to use derivatives as instruments of mass economic
destruction than help them manage economic risks. And of course, instead of
2000 pages of guidance (and the huge costs that go along with it), we’d have
20 pages.

Although I did not mention it in my blog post, I
could be reluctantly persuaded to allow hedge accounting for foreign
currency forwards, but that’s as far as I would go.

Best,
Tom

June 30, 2009 reply from
Bob Jensen

Hi Tom,

Southwest Airlines was hedging and not speculating when
they purchased options to hedge jet fuel prices. If prices went down, all
they lost was the relatively small price of the options (actually there were
a few times when the options prices became too high and Southwest instead
elected to speculate). If prices went up, Southwest could buy fuel at the
strike price rather than the higher fuel prices. If Southwest had instead
hedged with futures, forward, or swap derivative contracts, it is a bit more
like speculation in that if prices decline Southwest takes an opportunity
loss on the price declines, but opportunity losses do not entail writing
checks from the bank account quite the same as real losses from unhedged
price increases.

In any case, Southwest's only possible loss was the
premium paid for the purchase options and did not quite have the same
unbounded opportunity losses as with futures, forwards, and swaps. In
reality, companies that manage risks with futures, forwards, and swaps
generally do not have unbounded risk due to other hedging positions.

What you are really arguing is that accounting for most
derivatives should not distinguish “asymmetric-booking” hedging
derivative contracts from speculation derivative contracts. I
argue that failure to distinguish between hedging and speculation is very,
very, very, very misleading to investors. I do not think FAS 133 is an
"abject failure." Quite to the contrary (except in the case of credit
derivatives)!

I have to say I disagree entirely about “derivatives”
being the cause of misleading financial reporting. The current economic
crisis was heavily caused by AIG’s credit derivatives that were essentially
undercapitalized insurance contracts. Credit derivatives should’ve been
regulated like insurance contracts and not FAS 133 derivatives. Credit
derivatives should never have been scoped into FAS 133.

The issue in your post concerns derivatives apart from
credit derivatives, derivatives that are so very popular in managing
financial risk, especially commodity price risk and interest rate
fluctuation risk. Before FAS 119 and FAS 133 it was the wild west of
off-balance sheet financing with undisclosed swaps and forward contracts,
although we did have better accounting for futures contracts because they
clear for cash each day. Scandals were soaring, in large measure, due to
failure of the FASB to monitor the explosion in derivatives frauds. Arthur
Levitt once told the Chairman of the FASB that the FASB’s three biggest
problems, before FAS 133, were 1-derivatives, 2-derivatives, and
3-derivatives ---
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

When you respond to my post please take up the issue of
purchase contracts and non-contracted forecasted transactions since these
account for the overwhelming majority of “asymmetric-booking” derivatives
contracts hedges being reported today. Then show me how booking changes in
value of a hedging contract as current earnings makes sense when the changes
in value of the hedged item are not, and should not, be booked.

Then show me how this asymmetric-booking reporting of
changes in value of a hedging contract not offset in current earnings by
changes in the value of the item it hedges provides meaningful information
to investors, especially since the majority of such hedging contracts are
carried to maturity and all the interim changes in their value are never
realized in cash.

Show me why this asymmetric-booking of changes in value
of hedging contracts versus non-reporting of offsetting changes in the value
of the unbooked hedged item benefits investors. Show me how the failure to
distinguish earnings changes from derivative contract speculations from
earnings changes from derivative hedging benefits investors.

What you are really arguing is that accounting for such
derivatives should not distinguish hedging derivative contracts from
speculation derivative contracts. I argue that failure to distinguish
between hedging and speculation is very, very, very, very misleading to
investors.

Derivative contracts are now the most popular vehicles
for managing risk. They are extremely important for managing risk. I think
FAS 133 and IAS 39 can be improved, but failure to distinguish hedging
derivative contracts from speculations in terms of the booking of value
changes of these derivatives will be an enormous loss to users of financial
statements.

The biggest complaint I get from academe is that
professors mostly just don’t understand FAS 133 and IAS 39. I think this
says more about professors than it does about the accounting. In fairness,
to understand these two standards accounting professors have to learn a lot
more about finance than they ever wanted to know. For example, they have to
learn about contango swaps and other forms of relatively complex hedging
contracts used in financial risk management.

Finance professors, in turn, have to learn a whole lot
more about accounting than they ever wanted to know. For example, they have
to learn the rationale behind not booking purchase contracts and the issue
of damage settlements that may run close to 100% of notionals for executed
contracts and less than 1% of notionals for executory purchase contracts.
And hedged forecasted transactions that are not even written into contracts
are other unbooked balls of wax that can be hedged.

There may be a better way to distinguish earnings
changes arising from speculation derivative contracts versus hedging
derivative contracts, but the FAS 133 approach at the moment is the best I
can think of until you have that “aha” moment that will render FAS 133 hedge
accounting meaningless.

I anxiously await your “aha” moment Tom as long as you
distinguish booked from unbooked hedged items.

Bob Jensen

"The New Role of Risk Management: Rebuilding the Model," Interview with Wharton
professors Dick Herring and Francis Diebold, and also with John Drzik, who is
president and chief executive officer of Oliver Wyman Group, Knowledge@wharton,
June 25, 2009 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2268

If you are an AAA member it is an opportunity to add comments to the above
posting. You might mention your own reaction to the Taylor and Murthy research
paper on the AECM. Do you agree or disagree with the major findings of Taylor
and Murthy?

It is also an opportunity to thank Barry Rice for what he enabled you to
learn from the AECM over the years since 1996. It is also fabulous that the AECM
archived all this messaging.

The AAA Commons access page is at
https://commons.aaahq.org/signin
It can only be accessed by American Accounting Association members and invited
guests (some students).

The largest 500 companies regulated by the U.S.
Securities and Exchange Commission (SEC) are poised to submit quarterly
financial reports that, for the first time, will be tagged using XBRL code –
which will allow computers to "read" their content and make it easier for
people to find and analyze financial data contained in the reports. However,
a new study by researchers at North Carolina State University finds that
XBRL filings submitted voluntarily as part of an SEC pilot for the program
contained significant flaws. If the accuracy of the upcoming filings is not
significantly improved, the researchers say, these errors will undermine
confidence in the XBRL program from the very beginning.

The goal of XBRL is to make quarterly and annual
reports computer-readable, allowing investors, companies, finance
professionals and academics to sort and access data more efficiently.
"Rather than going through a report page by page to find the information
they're looking for, users can plug their requests into the computer and
have it pull up all relevant data," explains Dr. Eileen Taylor, an assistant
professor of accounting at NC State and co-author of the recent study on the
accuracy of the voluntary XBRL filings.

Another benefit of XBRL is that it requires
companies to use standardized tags for financial statement items, making it
easier for users to compare data from different companies. This is
significant because companies often use different terms to refer to the same
thing. "For example," Taylor says, "one company may refer to its 'operating
revenue,' while another company may use the term 'sales of goods net,' and
both mean the same thing. By using standardized tags, users can compare
apples to apples, which really levels the playing field for individual
investors," who may not have the time or expertise to find and accurately
compare data from these reports on their own.

But, while the XBRL concept is promising, the study
from NC State found that reports from companies that participated in the
voluntary pilot program contained multiple errors. "They were poorly
tagged," Taylor says, "and there were fundamental errors of accounting. One
report, for example, contained too many zeros – turning millions into
billions." In their abstract, the researchers note that "These errors are
serious because since XBRL data is computer-readable, users will not
visually recognize the errors, especially when using XBRL analysis
software." In other words, users won't be able to spot that something is
wrong.

Now the SEC is requiring that companies file their
reports in XBRL, as well as through traditional methods. The mandate is
being phased in, with the 500 largest companies required to submit XBRL
filings for the quarter ending June 15. The researchers are concerned that,
if the upcoming XBRL filings do not represent a significant improvement from
the voluntary reports, stakeholders in the financial community will not have
any faith in the XBRL program – and it will be rendered relatively
ineffective.

The study, "A Comparison of XBRL Filings to
Corporate 10-Ks – Evidence from the Voluntary Filing Program," examined XBRL
filings by 22 companies that participated in the SEC's voluntary pilot
program in 2006. The study was co-authored by Taylor, Drs. Al Y. S. Chen and
Jon Bartley, who are both professors of accounting at NC State. The study
will be presented at the American Accounting Association Annual Meeting
being held in New York City, Aug. 2-5.

Once Again:
The Controversy of Neutrality in the Setting of Accounting Standards

In
Concepts Statement No. 2, the FASB
asserts it should not issue a standard for the purpose of achieving some
particular economic behavior. Among other things, this statement implies that
the board should not set accounting standards in an attempt to bolster the
economy or some industry sector. Ideally, scorekeeping should not affect how the
game is played. But this is an impossible ideal since changes in rules for
keeping score almost always change player behavior. Hence, accounting standards
cannot be ideally neutral. The FASB, however, actively attempts not to not take
political sides on changing behavior that favors certain political segments of
society. In other words, the FASB still operates on the basis that fairness and
transparency in the spirit of neutrality override politics. However, there is a
huge gray zone that, in large measure, involves how companies, analysts,
investors, creditors, and even the media react to new accounting rules.
Sometimes they react in ways that are not anticipated by the FASB

Over the next 30 years,
Nassau County expects to spend $3.6 billion paying health care bills for its
retired workers. Already this year, it spent more for retirees' health care
than it did for their pensions, according to financial statements it plans
to publish Wednesday.

Suffolk County faces an even
higher liability, according to its latest accounting -- $4.1 billion over 30
years, according to county comptroller Joseph Sawicki.

Free health care for life is
a prized benefit of public employment, but its rapidly rising cost to
taxpayers is looming into view like the iceberg that sank the Titanic,
thanks to the phasing in of a national accounting rule known as GASB-45.

That rule, issued in 2004,
also applies to towns, villages, school districts and public authorities. It
requires the 30-year cost of retiree health benefits to be listed on their
annual financial reports. This year, for the first time, governments with as
little as $10 million in revenue will begin reporting those costs in their
financial statements, filed at the end of this month. But they are not
required to set aside money to cover those costs.

"While we're facing
difficult times, now is not the time to ignore this issue and push it
aside," said state Comptroller Tom DiNapoli Tuesday, calling the expense
"staggering."

New York State has the
highest costs in the nation for retired employees' medical care -- an
estimated $55 billion over the next 30 years. It, too, paid more last year
for retirees' health benefits than their pension costs. Those health costs
are only going to go up, warns DiNapoli, who has proposed creating a trust
fund governments can use to save for their retirees' health costs. That will
reduce the long-term expense, he argues.

But at the moment, county
officials seem more interested in finding ways to reduce the obligations
than set aside extra money to meet them.

"Knowledge of this figure
does not change the pressure on our hard-pressed county taxpayers since we
only pay one year's health care bill at a time," said Nassau Comptroller
Howard Weitzman, who last year worked with the county legislature on a new
benefits package for nonunion employees that increased the number of years
required for them to vest lifetime benefits. But his office acknowledged
that nonunion employees make up only a small share of the county workforce.

In Suffolk, County Executive
Steve Levy is also looking to trim benefits, and blamed the current
predicament on a series of nine government downsizings approved by the
legislature in eight years that were followed by new hires into many of the
same positions.

"Those early retirement
incentives of the 1990s are coming home to roost," he said.

Levy has required nonunion
employees to contribute at least 10 percent of their health benefits, and
said the issue will figure prominently in future contract talks.

"New rules have to be
written for new employees coming into the game," he said.

Neutrality is the
quality that distinguishes technical decision-making from political
decision-making. Neutrality is defined in FASB Concepts Statement 2 as the
absence of bias that is intended to attain a predetermined result. Professor
Paul B. W. Miller, who has held fellowships at both the FASB and the SEC,
has written a paper titled: "Neutrality--The Forgotten Concept in Accounting
Standards Setting." It is an excellent paper, but I take exception to his
title. The FASB has not forgotten neutrality, even though some of its
constituents may appear to have. Neutrality is written into our mission
statement as a primary consideration. And the neutrality concept dominates
every Board meeting discussion, every informal conversation, and every
memorandum that is written at the FASB. As I have indicated, not even those
who have a mandate to consider public policy matters have a firm grasp on
the macroeconomic or the social consequences of their actions. The FASB has
no mandate to consider public policy matters. It has said repeatedly that it
is not qualified to adjudicate such matters and therefore does not seek such
a mandate. Decisions on such matters properly reside in the United States
Congress and with public agencies.

The only mandate
the FASB has, or wants, is to formulate unbiased standards that advance the
art of financial reporting for the benefit of investors, creditors, and all
other users of financial information. This means standards that result in
information on which economic decisions can be based with a reasonable
degree of confidence.

A fear of information

Unfortunately, there
is sometimes a fear that reliable, relevant financial information may bring
about damaging consequences.
But damaging to whom? Our democracy is based on free dissemination of
reliable information. Yes, at times that kind of information has had
temporarily damaging consequences for certain parties. But on balance,
considering all interests, and the future as well as the present, society
has concluded in favor of freedom of information. Why should we fear it in
financial reporting?

Your post on 'neutrality' is very thought provoking and I am
especially appreciative of the link to Denny Beresford's article published
in 1989 in Financial Executive Magazine, which I had not recalled reading
for some time if ever; it is a great article.

I was fortunate to have Dr. David Solomons as my accounting theory professor
at Penn in 1982, and I have always been fascinated by the accounting
standard-setting process and Con. 2's qualitative characteristics of
financial reporting, in particular neutrality and representational
faithfulness, as well as the subject of accounting standard-setting vis-a-vis
public policy.

One of my favorite quotes from the term paper I wrote in Dr. Solomons' class
on the subject of 'Standard-Setting and Social Choice" was by Dale
Gerboth, in which Gerboth said:

“The
public accounting profession has acquired a unique quasi-legislative
power that, in important respects, is self-conferred. Furthermore, its
accounting ‘legislation’ affects the economic well-being of thousands of
business enterprises and millions of individuals, few of whom had
anything to do with giving the profession its power or have a
significant say in its use. By any standard, that is a remarkable
accomplishment.”
[Gerboth, Dale L., "Research, Intuition, and Politics in Accounting
Inquiry" The Accounting Review, Vol. 48, No. 3 (July 1973), pp. 475-482,
published by the American Accounting Association (cite is on pg 481).]

Returning to
Denny's 1989 article, I find it significant that he wrote:

"The
only mandate the FASB has, or wants, is to formulate unbiased standards
that advance the art of financial reporting for the benefit of
investors, creditors, and all other users of financial information. This
means standards that result in information on which economic
decisions can be based with a reasonable degree of confidence. ... Unfortunately,
there is sometimes a fear that reliable, relevant
financial information may bring about damaging consequences."

I believe the
above statement makes sense, and extending it further, the point I'd make
(let me note now these are my personal views) is that: it's one thing if
people want to 'throw caution to the wind' so to speak by saying 'ignore
public policy (or economic) consequences' - but it's another thing to say
that when the proposed accounting treatment would not necessarily 'result in
information on which economic decisions can be based with a reasonable
degree of confidence" or when 'reliability' has been overly sacrificed for
perceived 'relevance.'

Another
consideration should be - 'relevance' for whom and by whom, e.g. relevance
for some who base their own business or consulting service on, e.g.
fire-sale or liquidation prices, vs. e.g. going concern models of
valuation?

Said another
way, I think it's one thing to risk economic upheaval for high quality
standards, vs. risk economic upheaval for accounting standards of
questionable relevance, reliability or representational faithfulness.

Maybe the
concept of 'first, do no harm' is another way of saying this, i.e., do not
inflict unnecessary harm, particularly without exploring the reasonableness
of alternatives, and exploring motivations of all parties involved, and the
ability for investors to truly 'understand' what's behind numbers reported
in accordance with the accounting standards, and the reliability of those
numbers.

Rebecca McEnally & I wrote an article on Neutrality
in Financial Statements for the FASB Report in 2003 from the perspective of
the investor/creditor in which we support the concept of attempting to
achieve neutrality rather than conservatism (or prudence) in financial
reporting and why. (Available from me if anyone wants.)

One of the issues I've encountered over the years
is an elevation of "reliability" in financial reporting to a stature I don't
believe is warranted.

What do we really mean by reliable information?
Someone can demonstrate how it is calculated? Most would get the same answer
if asked to measure? Is something reliable when it's easy to audit?

Every balance sheet item including cash & cash
equivalent has an element of estimation in the measurement, especially in
mult-national companies that have selected functional currencies and
translated them into the presentation currency of the group.

Even with a goal of "neutrality" as one of its
qualitative characteristic, financial reporting will always be subjective.
Lack of "reliable measurement" can be used to do that. Measurements even at
cost require decisions about what's "directly attributable" and what isn't.

It happened to Archimedes in the bath. To Descartes
it took place in bed while watching flies on his ceiling. And to Newton it
occurred in an orchard, when he saw an apple fall. Each had a moment of
insight. To Archimedes came a way to calculate density and volume; to
Descartes, the idea of coordinate geometry; and to Newton, the law of
universal gravity.

Five light-bulb moments of understanding that
revolutionized science.

In our fables of science and discovery, the crucial
role of insight is a cherished theme. To these epiphanies, we owe the
concept of alternating electrical current, the discovery of penicillin, and
on a less lofty note, the invention of Post-its, ice-cream cones, and
Velcro. The burst of mental clarity can be so powerful that, as legend would
have it, Archimedes jumped out of his tub and ran naked through the streets,
shouting to his startled neighbors: "Eureka! I've got it."

In today's innovation economy, engineers,
economists and policy makers are eager to foster creative thinking among
knowledge workers. Until recently, these sorts of revelations were too
elusive for serious scientific study. Scholars suspect the story of
Archimedes isn't even entirely true. Lately, though, researchers have been
able to document the brain's behavior during Eureka moments by recording
brain-wave patterns and imaging the neural circuits that become active as
volunteers struggle to solve anagrams, riddles and other brain teasers.

Following the brain as it rises to a mental
challenge, scientists are seeking their own insights into these light-bulb
flashes of understanding, but they are as hard to define clinically as they
are to study in a lab.

To be sure, we've all had our "Aha" moments. They
materialize without warning, often through an unconscious shift in mental
perspective that can abruptly alter how we perceive a problem. "An 'aha'
moment is any sudden comprehension that allows you to see something in a
different light," says psychologist John Kounios at Drexel University in
Philadelphia. "It could be the solution to a problem; it could be getting a
joke; or suddenly recognizing a face. It could be realizing that a friend of
yours is not really a friend."

These sudden insights, they found, are the
culmination of an intense and complex series of brain states that require
more neural resources than methodical reasoning. People who solve problems
through insight generate different patterns of brain waves than those who
solve problems analytically. "Your brain is really working quite hard before
this moment of insight," says psychologist Mark Wheeler at the University of
Pittsburgh. "There is a lot going on behind the scenes."

In fact, our brain may be most actively engaged
when our mind is wandering and we've actually lost track of our thoughts, a
new brain-scanning study suggests. "Solving a problem with insight is
fundamentally different from solving a problem analytically," Dr. Kounios
says. "There really are different brain mechanisms involved."

By most measures, we spend about a third of our
time daydreaming, yet our brain is unusually active during these seemingly
idle moments. Left to its own devices, our brain activates several areas
associated with complex problem solving, which researchers had previously
assumed were dormant during daydreams. Moreover, it appears to be the only
time these areas work in unison.

"People assumed that when your mind wandered it was
empty," says cognitive neuroscientist Kalina Christoff at the University of
British Columbia in Vancouver, who reported the findings last month in the
Proceedings of the National Academy of Sciences. As measured by brain
activity, however, "mind wandering is a much more active state than we ever
imagined, much more active than during reasoning with a complex problem."

She suspects that the flypaper of an unfocused mind
may trap new ideas and unexpected associations more effectively than
methodical reasoning. That may create the mental framework for new ideas.
"You can see regions of these networks becoming active just prior to people
arriving at an insight," she says.

In a series of experiments over the past five
years, Dr. Kounios and his collaborator Mark Jung-Beeman at Northwestern
University used brain scanners and EEG sensors to study insights taking form
below the surface of self-awareness. They recorded the neural activity of
volunteers wrestling with word puzzles and scanned their brains as they
sought solutions.

Some volunteers found answers by methodically
working through the possibilities. Some were stumped. For others, even
though the solution seemed to come out of nowhere, they had no doubt it was
correct.

In those cases, the EEG recordings revealed a
distinctive flash of gamma waves emanating from the brain's right
hemisphere, which is involved in handling associations and assembling
elements of a problem. The brain broadcast that signal one-third of a second
before a volunteer experienced their conscious moment of insight -- an
eternity at the speed of thought.

The scientists may have recorded the first
snapshots of a Eureka moment. "It almost certainly reflects the popping into
awareness of a solution," says Dr. Kounios.

In addition, they found that tell-tale burst of
gamma waves was almost always preceded by a change in alpha brain-wave
intensity in the visual cortex, which controls what we see. They took it as
evidence that the brain was dampening the neurons there similar to the way
we consciously close our eyes to concentrate.

"You want to quiet the noise in your head to
solidify that fragile germ of an idea," says Dr. Jung-Beeman at
Northwestern.

At the University of London's Goldsmith College,
psychologist Joydeep Bhattacharya also has been probing for insight moments
by peppering people with verbal puzzles.

Continued in article

Jensen Comment
I'm having a hard time finding a worthy "aha" moment in accountancy. It
certainly would not be Pacioli's double entry contribution since double entry
accounting is thought to have been used for over 1,000 years before Pacioli.
There have been aha moments in the invention of derivative contracts, but none
of them to my knowledge are attributable to accountants. There have been some
seminal accounting ideas such as ABC costing, but I think a team of people at
Deere is credited for ABC Costing.

Contrary to a
recent statement in this forum, Dollar-Value Lifo (DVL) was not developed by
a professor. The father of DVL was Herbert T. McAnly, who retired in 1964 as
a partner at Ernst & Ernst after 44 years with the firm. Throughout his
career, McAnly was known as "Mr. LIFO."

Although he did not
develop LIFO, which had been around for decades in the form of the
base-stock method, he did develop DVL after the Internal Revenue began
accepting LIFO from all types of companies. The Treasury would probably
never have agreed to allow all companies to use LIFO (in 1939) had they been
able to prognosticate McAnly's idea. He first described the concept in an
address delivered at the Accounting Clinic and the Central States Accounting
Conference in Chicago in May 1941. His concept was finally accepted by the
IRS following the Hutzler Brothers Co. case in 1947 (8 TC 14 (1947)). He
later worked with the Treasury Department trying to get more practical
regulations relating to LIFO.

With respect to your recent posting on the AAA
Commons, I would like to make a nomination for an "Aha" moment in
accounting. I suggest that Donaldson Brown's invention of the expanded
return-on-investment formula (DuPont formula) in 1914 was such a moment. In
fact, as I recall, Brown called it his "Eureka" moment in his biography.

In 1914, Brown was asked for a report on the
performance of several operating departments. It was at this point that he
developed the procedure now known as the DuPont formula. Brown recounted the
event in his memoirs as follows:

“An event occurred in l914 which proved to be
the turning point of my business career. The circumstances which led up
to it were accidental, and I have often wondered what might have been my
fate and fortune in industrial management if I had not, that summer, hit
upon the mathematical equation (R=TxP) which serves as the heading of
this chapter.

Mr. Barksdale was in bad health and was forced
to take extended time off, which he spent with his family in Westport,
New York. During a period of such absence from the office, the President
of the company, Coleman duPont called for a study and report on the
performance and accomplishments of the several operating departments. I
undertook the job. …

The basis of my report gauging the performance
of the various operating departments was a simple mathematical formula:
R = T x P. The factor R represented the rate of return on capital
invested, which is a final and fundamental measure of industrial
efficiency in terms of management’s primary responsibility. The T stood
for the rate of turnover of invested capital, and P for the percentage
of profit on sales. On the investment side T was broken down into
components, embracing plant and other fixed investment items, as well as
amounts tied up in working capital in various categories such as raw
materials, work in process, finished product, accounts receivable and
required operating cash balances.

When teaching about the time value of money accounting and finance
professors often make reference to losses expected when a "little old lady tucks
cash under her mattress." Now we have to add an added risk to the risk of losing
the time value of money.

An Israeli woman mistakenly threw out a mattress
with $1 million inside, setting off a frantic search through tons of garbage at
a number of landfill sites. The woman told Army Radio that she bought her
elderly mother a new mattress as a surprise on Monday and threw out the old one,
only to discover that her mother had hidden her life savings inside.
"Woman mistakenly junks $1m mattress," Jerusalem Post, June 10, 2009 ---
http://www.jpost.com/servlet/Satellite?cid=1244371059980&pagename=JPost%2FJPArticle%2FShowFull

In our paper Does Corporate
Transparency Contribute to Efficient Resource Allocation?
which was recently accepted for publication in the Journal of Accounting
Research, we examine whether the country-level information environment
positively affects the timely reallocation of resources in response to
growth shocks (or changes in growth opportunities) by improving the transfer
of resources from industries which experience negative growth shocks to
those that experience positive growth shocks.

We hypothesize that if a pair of countries has a
high level of corporate transparency in each country, then investors are
better able to recognize and direct resources towards industries which
experience positive growth shocks and away from industries which experience
negative growth shocks, irrespective of financial development. Our sample
consists of calculated correlations in industry growth rates for 666 country
pairs based on 37 unique countries and 37 manufacturing industries for the
period 1980-1990 using industry-level data from a United Nations Industrial
Development Organization (2000) database. We merge these correlations with
country-level measures of corporate transparency that capture the quality of
the financial reporting regime, the intensity of private information
collection, the quality of information dissemination structures, the level
of earnings opacity and stock price synchronicity.

We find transparency is positively associated with
the correlation in industry-specific growth rates across country pairs. This
positive association is consistent with the notion that corporate
transparency helps to channel resources to those particular industries with
good growth opportunities and hence contributes to more effective
inter-sector allocation of resources. These results generally hold across
alternative measures of transparency. In addition, we find that the impact
of corporate transparency on the co-movement in growth rates is greater for
country pairs with similar levels of economic development. Third, we find
that the residual transparency metrics positively explain co-movements in
industry-specific growth rates among country pairs, which indicates that
transparency over and above that predicted by the underlying institutions
facilitates resource allocation. Finally, we measure a country’s level of ex
ante growth opportunities using the price-earnings ratio of global industry
portfolios weighted by a country’s industrial mix and find that it is only
countries with high transparency where there is an association between ex
ante global growth opportunities of firms (within a country) and the
country’s realized ex post growth in real GDP per capita. This result is
consistent with the argument that firms in more transparent settings are
better able to exploit global growth shocks and thus achieve higher realized
growth rates.

Talk About a Competitive Advantage for Chrysler: Immune from Safety
LawsuitsPaul Sheridan is former head of Chrysler's Minivan
Safety Leadership Team and winner of the 2005 Civil Justice Foundation National
Champion award for his work in transportation safety. He has reviewed the Obama
administration's Chrysler bailout plan and notes that it strips away the rights
of some people to receive compensation for safety defects in Chrysler products.
The president had declared that Chrysler vehicle owners could rely on the
government to back repairs covered under warranty. If your transmission fails,
he will stand with you. However, if your spouse burned to death due to a fuel
system defect, and you are actively seeking redress through product litigation,
Obama does not stand with you....There is no precedent for this blatant abuse of
the unsuspecting taxpayer who had no say and no representation. Essentially,
Obama is demanding that Chrysler safety-defect victims pay to have their own
lawsuits dismissed. Is this vicious fleecing allowed by the Constitution?Hank, "Obama Bailout Plan Kills
Safety Lawsuits," Federal Review, May 31, 2009 ---
http://www.federalreview.com/2009/05/obama-bailout-plan-kills-safety.htm
Jensen Comment
Of course if your Ford has a safety defect you can sue Ford into the ground. I
wonder how these guarantees and lawsuit protections factor into accounting
differences between Chrysler and Ford?

The Tale of Joseph E. Connor

While leading Price Waterhouse, he called for
regulation of the then-Big Eight public accounting firms, stated that auditors
duck responsibility for fraud, and expressed disapproval of the work of the
FASB.

SUMMARY: This
obituary describes a man who led Price Waterhouse prior to its merger with
Coopers & Lybrand, then went on to lead administration at the U.N.,
significantly improving its operational efficiencies. While leading Price
Waterhouse, he called for regulation of the then-Big Eight public accounting
firms, stated that auditors duck responsibility for fraud, and expressed
disapproval of the work of the FASB.

CLASSROOM APPLICATION: The
article can be used to introduce the big public accounting firms, their role
in society and financial markets, and the leadership abilities that the
accounting and auditing professions can develop. The need for accountants'
and auditors' ethical strengths also can be made evident using this piece.

QUESTIONS:
1. (Introductory)
What firm did Mr. Connor, the subject of this obituary, lead? With what
other public accounting firm did Mr. Connor's firm merge?

2. (Introductory)
What are the names of the other large public accounting firms presently
operating in the U.S.?

3. (Advanced)
Consider Mr. Connor's position in 1978 that public accounting was "becoming
a semi-public institution." How are public accounting firms operated? How
are their operations regulated? Consider in particular, the public firms
that audit the companies that are publicly-traded on U.S. exchanges.

4. (Advanced)
Mr. Connor also argued that "auditors duck responsibility for fraud." What
steps must an auditor take when fraud is detected? Have those requirements
changed over time?

5. (Advanced)
When he moved to the U.N., Mr. Connor described the operation as
"precariously balanced" with "no capital and no reserves." What do these
statements mean?

6. (Advanced)
How difficult do you think it was for Mr. Connor to express the opinions he
stated during his career? How have his arguments borne out over time?

Joseph E. Connor, who died May 6 at age 77, was a
reform-minded chairman of Price Waterhouse & Co. who went on to lead a
restructuring at the United Nations as Undersecretary General for
Administration and Management.

At the U.N., where he served from 1994 to 2002, Mr.
Connor oversaw a reduction in staffing in what was generally seen by U.S.
officials as a bloated institution. Relations got so bad that the U.S. for
years underpaid its dues in protest until reforms instituted by Mr. Connor
led the U.S. to pay arrears in 1999. Mr. Connor's was a loud and insistent
voice that Washington pay up.

"His private-sector experience was invaluable,"
said former U.N. secretary general Kofi Annan, who credits Mr. Connor with
introducing modern management practices.

At Price Waterhouse, where Mr. Connor was chairman
for a decade starting in 1978, he became a lightning rod by advocating
increased public oversight of the "Big Eight" accounting firms that
dominated audits of public companies. "We must recognize that we have become
a semi-public institution," he told Fortune in 1978.

He testified on accounting rules before Congress
and was critical of the Financial Accounting Standards Board, a professional
rule-maker. He also urged that accountants should publicly reveal fraud when
they detected it in their clients' books.

"Auditors have been ducking responsibility for
fraud for too long," he told the Independent newspaper in 1988. He added
that when he had said such things publicly in the past, "I had to buy myself
a lot of lunches for some time afterwards."

As a freshly minted Columbia University M.B.A. in
1956, Mr. Connor went to work at Price Waterhouse in New York. He became a
partner in 1967 and was put in charge of the firm's Western U.S. operations
in 1975. There his responsibilities included overseeing the Price Waterhouse
partner who counted the votes for the Academy Awards, though he never knew
the winners in advance himself, family members say. His own practice
included auditing Exxon and the World Bank.

As Price Waterhouse chairman, Mr. Connor reduced
bureaucracy, even while the firm was doubling from 400 to 800 partners. In
1988, he was elected chairman of the Price Waterhouse World Firm, which
coordinates the activities of the company's local partnerships around the
globe.

"Our slogan since we began has been, 'Be strong in
the capital exporting countries,'" he told the Journal of Commerce in 1987,
adding that he was planning to promote business in Germany and Japan.

Experienced as he was with auditing top firms, Mr.
Connor found the U.N. a rude awakening. "I've never seen anything so
precariously balanced at this scale," he told the New York Times in 1995.
"There's no capital and no reserves." He was forced to divert money meant
for peacekeeping to staff salaries, and publicly compared such financial
legerdemain to a Ponzi scheme.

In addition to hectoring American officials into
paying the U.S.'s bills, Mr. Connor also proposed selling bonds based on
U.S. and other nations' U.N. obligations. The idea came to naught as the
U.N. charter doesn't envision dealing with financial markets.

This paper examines the effects of the
Sarbanes-Oxley Act (SOX) by studying both foreign firms’ decisions to list
in the US or the UK and local market stock price reactions to US listing
announcements before and after SOX. This research design allows us to
overcome difficulties with other studies in the literature that have lead to
mixed results. We have three main findings: First, we estimate that if SOX
had been a complete surprise to the market, US equity values would increase
between 10% and 16%. Second, small firms do not react differently to SOX
than large firms. Third, minority investors place greater value on the
increased manager accountability imposed by SOX than on the costs associated
with the increased accountability. In summary, we find evidence that SOX
imposed costs upon managers and insiders but was beneficial for minority
investors.

Those of you who watched the FASB relax FAS 157 fair value rules under
heavy political pressure my be even more fascinated by the IASB reaction to even
heavier European Union fair value rule relaxation pressure being placed on the
IASB

This Statement is intended to establish general
standards of accounting for and disclosure of events that occur after the
balance sheet date but before financial statements are issued or are
available to be issued. It requires the disclosure of the date through which
an entity has evaluated subsequent events and the basis for that date—that
is, whether that date represents the date the financial statements were
issued or were available to be issued. This disclosure should alert all
users of financial statements that an entity has not evaluated subsequent
events after that date in the set of financial statements being presented.

In particular, this Statement sets forth:

The period after the balance sheet date during
which management of a reporting entity should evaluate events or
transactions that may occur for potential recognition or disclosure in the
financial statements;

The circumstances under which an entity should
recognize events or transactions occurring after the balance sheet date in
its financial statements;

The disclosures that an entity should make about
events or transactions that occurred after the balance sheet date.

When Private Equity Owners Screw Their Bankers
The sad part is that Wachovia did not require independent audits
Now there are no deep pocket auditors to sue

Wachovia, for instance, provided tens of millions of
dollars in loans and lines of credit backed by assets to Archway despite the
fact the company had not had a formal independent audit of its financial
statements in three years. A spokeswoman for Wells Fargo, which acquired
Wachovia last year, declined comment.
"Oh, No! What Happened to Archway?" by Julie Creswell, The New York Times,
May 30, 2009 ---
http://www.nytimes.com/2009/05/31/business/31archway.html?_r=1

SITTING in his office late one evening in April
last year, Keith Roberts, the director of finance for the Archway & Mother’s
Cookie Company, stared in shocked silence at the numbers on his desk.

He knew things had been bad — daily reports he had
been monitoring for six months showed that cookie sales at the company had
been dismal. But the financial data he was looking at showed much more
robust sales.

“Where on earth had all of these sales come from?”
Mr. Roberts recalls thinking to himself.

Tired, but intrigued, he began digging through
orders and shipping and inventory records until, well after midnight, he
reached the conclusion that Archway, based in Battle Creek, Mich., was
booking nonexistent sales.

He reasoned that sham transactions allowed Archway,
which was owned by a private-equity firm, Catterton Partners, to maintain
access to badly needed money from its lender, Wachovia. Mr. Roberts’s
investigation eventually caused Wachovia to pull its financing lines,
helping to push Archway into bankruptcy last fall. Two other food companies
picked off much of its assets earlier this year for $42 million and are
churning out the brands’ cookies again.

As accounting scandals go, Archway is no Enron. Not
in the size of the possible accounting fraud itself — sales were probably
overstated by a few million dollars — or in its sophistication or ingenuity.
Yet what court documents filed in Delaware describe as a fairly simplistic
fraud went on for months, seemingly missed by the company’s lenders as well
as its savvy, private-equity stewards.

And Archway’s collapse is a reminder of the
apparent lengths to which some of the nation’s biggest banks went to do
deals with private-equity firms during the recent buyout boom.

Wachovia, for instance, provided tens of millions
of dollars in loans and lines of credit backed by assets to Archway despite
the fact the company had not had a formal independent audit of its financial
statements in three years. A spokeswoman for Wells Fargo, which acquired
Wachovia last year, declined comment.

Archway’s failure also raises questions about how
some private-equity shops operate. When they acquire broken companies, the
firms pledge to use their financial, strategic and operational expertise to
fix them. The firms receive management fees from their portfolio companies
while also charging investors — large institutions and pension funds — fees
for managing their money.

Although Catterton placed three of its partners on
Archway’s board, naming one as vice chairman, it hired a management company,
Insight Holdings, to handle day-to-day operations at Archway. Several former
executives and employees who worked at Archway’s headquarters say Insight
conducted most of its oversight of the company via telephone and
videoconferences.

The Catterton partners, these former employees say,
were never seen at Archway. Catterton and Insight nonetheless collected
about $6 million in management fees and compensation during their nearly
four-year tenure running Archway, court documents assert.

In an e-mailed statement, a spokeswoman for
Catterton said the firm did make on-site visits to Archway and stopped
receiving fees in October 2007. In total, she said, Catterton received only
$2.75 million in fees, half of which was distributed to its investors.

A multitude of lawsuits have been filed in
connection with Archway’s collapse, including suits brought by former
employees as well as independent distributors. In one suit filed earlier
this year in Delaware bankruptcy court, a committee of unsecured creditors
contends that the alleged accounting fraud continued for as long as it did
because of the “control, participation and acquiescence” of Catterton.

An accounting rule that governs how banks book
acquired loans is making it possible for banks that purchased bad loans to
reap billions.

Applying this regulation — known as the purchase
accounting rule — to mortgages and commercial loans that lost value during
the credit crisis gives acquiring banks an incentive to mark down loans they
acquire as aggressively as possible, says RBC Capital Markets analyst Gerard
Cassidy.

"One of the beauties of purchase accounting is
after you mark down your assets, you accrete them back in," Cassidy told
Bloomberg. "Those transactions should be favorable over the long run."

Here’s how it works: When JPMorgan bought WaMu out
of receivership last September, it used the purchase accounting rule to
record impaired loans at fair value, marking down $118.2 billion of assets
by 25 percent.

Now, JPMorgan says that first-quarter gains from
the WaMu loans resulted in $1.26 billion in interest income and left the
bank with an accretable-yield balance that could result in additional income
of $29.1 billion.

So JPMorgan, Wells Fargo, Bank of America, and PNC
Financial Services all stand to make big bucks on bad loans they bought from
Washington Mutual, Wachovia, Countrywide and National City.

Their combined deals provide a $56 billion in
accretable yields, which is the difference between the value of the loans on
the banks’ balance sheets and the cash flow they’re expected to produce.

However, it’s tough to tell how much the yield will
increase the acquiring banks’ total revenues because banks don’t disclose
all their expenses and book the additional revenues over the lives of the
loans.

Thanks for providing fodder for what I hope will be
a "fun" blog post. Under APB 16, you had to evaluate the adequacy of the
allowance for bad debts in an acquisition. With the objective of curbing
this particular abuse, the SEC issued a Staff Accounting Bulletin (SAB
Codification Topic 2.B.5) that constrained the acquiror from changing the
allowance for bad debts, unless the plans for collection was fundamentally
different.

The new problem arises, because when the loans were
held by the acquiree, they were measured at contractual amount less the
allowance for bad debts. Upon acquisition, they now have to be measured at
fair value. If the acquirer wants to maximize future profits, it will
maximize the difference between the old and new carrying value, subject to
the following considerations: (1) auditor and/or SEC push back; (2) future
goodwill impairment charges, and (3) capital adequacy regulations.

As to Denny's comment about ultimate collectibility,
current managers may not care if the loans go further south some years from
now. This generation will be compensated based on accounting profits over
the next 2-3 years -- and will be long gone before the proverbial stuff hits
the fan.

The more things change, the more they remain the
same. I think that the biggest lesson here, Bob, and something I expect you
will react to, is that multi-attribute accounting standards don't work.

Best,
Tom

May 29, 2009 reply from Bob Jensen

Hi Tom,

When I first learned about how
business firms were exploiting derivative financial instruments contracts in
large measure to avoid accounting rules, and before FAS 119/133 issuance, I
attended a workshop in Orlando back in the 1980s conducted by Deloitte's
derivatives accounting expert John Smith (who later did a lot of IAS 39 work
for the IASB).

John told us about a Deloitte client
in L.A. that was behaving so strangely that the auditor in charge brought it
to John's attention (John was the top research partner in Deloitte at the
time). Bank X was repeatedly taking reversing positions on an interest rate
swap in a manner such that each time a reversing position was taken there
was an ultimate cash flow loss. It seemed that Bank X was making a terrible
mistake. John Smith posed this problem as a case to us derivatives
accounting neophyte professors in the audience in Orlando.

I recall that the first professor to
shout out the answer from the audience was Hugo Nurnberg. Hugo was the first
among us neophytes to recognize that, prior to FAS 133 rules, Bank X was
making harmful economic decisions just to "frontload income" as Hugo put it.
By frontloading income, the CEO got bigger bonuses in what was a bit like
Ponzi damage to shareholders. Each year frontloaded income in similar
contracting grows by enough to cover tailing cash flow losses. Bonuses and
share prices accordingly grow and grow until, dah, frontloaded income is no
longer sufficient to cover the tailing cash flow losses. I wonder if a
California relative of Bernie Madoff was running Bank X. By the time
the Ponzi exploded the Bank X CEO was probably living in luxury in Hawaii.

This was one of the first times I
became aware of how executives are willing to maximize personal gains at the
ultimate expense of the shareholders for whom they are acting as agents.
Since the roaring derivatives fraud days of the 1990s such behavior became
the rule rather than the exception, which is why we're in such a dire
economic crisis today. Alan Greenspan and Chris Cox belatedly admitted that
they "made mistakes" by assuming bankers would put shareholder interests
above their own personal greed ---
http://www.trinity.edu/rjensen/2008Bailout.htm#SEC

I wonder if this current TARP poison
plan is a bit of a Ponzi scheme to inflate banking share prices in what will
once again be a royal screwing of investors?

From a MoneyNews.com story published this Wednesday headlined "Banks
Stand to Reap Billions from Purchased Bad Loans,"
came an account of a jaw-dropping transaction. It was spawned by FAS 141(R),
the latest and greatest standard on accounting for business combinations:

"When JPMorgan bought WaMu out of receivership last September, it used the
purchase accounting rule [FAS 141(R)] to record impaired loans at fair
value, marking down 118.2 billion of assets by 25 percent.

Now, JPMorgan says its first-quarter gains from the WaMu loans resulted in
$1.26 billion in interest income and left the bank within an accretable-yield
balance that could result in additional income of $29.1 billion."

Business combination accounting has forever been fertile ground for earnings
and balance sheet management for one simple reason: the opportunity to tweak
the amounts reported for the assets acquired and liabilities assumed, with
the ultimate objective of brightening post-acquisition earnings reports.
But, as tiresome as that old game might be, the kind of maneuver that
JPMorgan's management has engineered is a novel twist on an old loophole
that had once been closed pretty tightly by the SEC.

The Closed Loophole that Would Be Re-Opened by the FASB

Once the "pooling of interests" method of business combination accounting of
APB 16 was abolished with the advent of FAS 141 (not to be confused with FAS 141(R)),
the most basic surviving principle of business combination accounting became
thus: the acquisition of a business should always be reflected on the
financial statements of the acquiror by assigning a new carrying amount to
each of the acquired company's assets and liabilities. This new carrying
amount would be updated, based on current assumptions and estimates
regarding the future role of the acquired assets and liabilities in the
combined entity. The implementation of this principle had long been known as
the "purchase accounting" method for business combinations.

With certain important exceptions, SFAS 141 mandated that new carrying
amounts for assets acquired in a business combinations would be based on
their fair values. The exception that is germane to the JPMorgan story
pertains to loans (i.e., trade receivables, interest-bearing loans and
marketable debt securities classified as held-to-maturity). The measurement
bases for these items were carried forward from APB 16's version of the
purchase accounting method: a gross amount reduced by an appropriate
allowance for uncollectible accounts. This exception to loan measurement was
important, because it also meant that a 1986 SEC staff position would still
be applicable to purchase accounting.

At that time, the SEC saw fit to put a stop to unwarranted increases in the
allowance for loan losses as part of the business combination transaction.
Increases to loan loss allowances would mathematically transfer future loan
losses to goodwill, where they would be deferred indefinitely, with the
effect of reporting inflated earnings in future periods as the loans were
eventually settled for more than their understated carrying amounts. Staff
Accounting Bulletin 61 (Topic 2-A(5)) states that the SEC would not permit
any adjustments of the acquiree's
estimate of loan loss reserves, unless the acquiror's plans for
ultimate recovery of the loans were demonstrably different from the plans
that had served as the basis for the acquiree's estimates of the loss
reserves.

FASB Amnesia?

FAS 141(R) did away with the "purchase method" and established the
"acquisition method" of accounting for business combinations. It apparently
did so out of a belief that measurements of assets and liabilities that are
based on the most current information available are usually, if not always,
preferable to valuations based on less-current information. The JPMorgan
case glaringly points to a significant flaw in that belief: inconsistent
application of fair value could be more harmful than consistent
application of a less desirable attribute. As to the case at hand:

§
WaMu, as is quite common, accounted for its loans based on a
held-to-maturity model. That is, except for recognizing declines in
creditworthiness, the loan carrying amount is based on the original
contractual terms; interest is accrued by multiplying the net carrying
amount by the yield to maturity as of the date the loan was
originated/acquired.

§
Even though the market value of these loans had declined significantly as
they turned toxic, WaMu apparently was not required to record losses to
bring the loans down to their fair values.

§
JPMorgan, when acquiring WaMu, was required by FAS 141(R) to mark the loans
to market. Subsequent
accounting by JPMorgan will continue the WaMu the held-to-maturity model.

It would be a pretty safe bet that JPMorgan was very 'conservative' in their
estimates of fair value for the loans; that's because the lower the fair
value, the higher the yield to maturity, and the higher the amount of
reported future earnings. Of course, there are some limits to JPMorgan's
estimate of fair value: auditor pushback, SEC review, increased risk of
goodwill impairment charges, and capital adequacy regulations. But, at least
in this case, it is possible to become rich without being greedy.

Where is the SEC!?

Maybe there has been more coverage of this issue, but I haven't seen it;
kudos to its author, Julie Crawshaw of Newsmax. If we are concerned that
bank executives are being overcompensated, especially on the taxpayers'
dime, here is a prime example of where insufficient oversight has spawned a
new source of moral hazard.

For starters, the SEC should put a stop to this obvious and blatant abuse,
immediately. They should issue another SAB, carving out the
offending provision of FAS 141(R) and restoring the long-established and
functioning status quo. Every company that benefitted from the ill-conceived
accounting rule should be forced to retroactively restate their earnings –
especially any financial institution on the government dole.

Perhaps the lack of permanent leadership in the Commission's Office of the
Chief Accountant is contributing to a lack of attention to this obvious
problem, but it is in no way an excuse. Also, this is a problem created by
the FASB. Let's be charitable and call it an unintended consequence, but
whatever the cause, the FASB should move to fix it forthwith. I'm suggesting
that the SEC should act first, solely because they have the demonstrated
capability of being able to move the fastest. That's because a SAB doesn't
have to be exposed for comment before it can be issued.

But, lacking any actions by either the FASB or SEC to put the cat back in
the bag, auditors (perhaps via the PCAOB), and boards should be put on
notice of a new potential scheme to inflate executive compensation in the
absence of actual value creation for stakeholders. If a single dime of
executive compensation comes out of accreted excess earnings from these
business combination games, I hope that private securities lawyers will
round up the proxies and the lawsuits, settling for nothing less than "a
pound of flesh."

A larger lesson is important to briefly discuss in order to understand how
this kind of loophole can occur: in accounting for financial assets, the
only workable system is comprehensive mark-to-market, all of the time. The
current situation is a consequence (intended or otherwise) of the piecemeal
approach pursued by the FASB (and IASB) towards fair value accounting.

"PCAOB Rips E&Y on Revenue Recognition: Two of Ernst & Young's
clients had to restate financial results after the accounting-firm overseer
found departures from GAAP," by Sarah Johnson, CFO.com, May 27, 2009 ---
http://www.cfo.com/article.cfm/13725058/c_13725042

Ernst & Young failed to note when two clients
strayed from revenue-recognition rules, according to the latest inspection
report on the Big Four firm by the Public Company Accounting Oversight
Board. Consequently, the regulator's sixth annual inspection of E&Y resulted
in those clients having to restate their previously issued financial
statements to make up for the departure from U.S. generally accepted
accounting principles.

These companies — whose identity the PCAOB keeps
confidential — had "failed" to fully follow FAS 48, Revenue Recognition When
Right of Return Exists. The rule calls on companies to, at the time of sale,
make reasonable estimates of how many products that customers will return as
a factor in deciding when revenue can be recorded.

Further criticizing the audit firm for its work on
a third client, the PCAOB claims E&Y didn't test the issuer's VSOE, or
vendor-specific objective evidence, which is used to figure out whether the
amount of revenue recognized for individual parts of a technology contract
was reasonable.

The PCAOB noted the revenue recognition audit
deficiencies mentioned here, as well as several others at eight of E&Y's
clients after reviewing the firm's work between April and December of last
year. The deficiencies were linked to the firm's national office in New York
and 22 of its 85 U.S. offices. These errors were significant enough for the
oversight board to conclude the firm "had not obtained sufficient competent
evidential matter to support its opinion on the issuer's financial
statements or internal control over financial reporting."

The PCAOB also criticized E&Y for not fully
exploring a client's revenue contracts to see how their terms could affect
the issuer's revenue recognition, for not doing enough work to assess the
valuation of another issuer's securities, and for relying on information an
issuer had deemed unreliable for estimating an income-tax valuation
allowance.

To be sure, eight clients may not be many in terms
of the number of audits looked at by the oversight board, or when taking
into account that E&Y audits more than 2,300 publicly traded companies. The
PCAOB, however, doesn't specify how many audits it reviewed and discourages
readers of its inspection reports from drawing conclusion on a firm's
performance based solely on the number of the reported deficiencies
mentioned. "Board inspection reports are not intended to serve as balanced
report cards or overall rating tools," the PCAOB notes.

For its part, E&Y, in all but two of the
deficiencies cited, revisited its work and made changes. "Although we do not
always agree with the characterization in the report ... in some instances
we did agree to perform certain additional procedures or improve aspects of
our audit documentation," E&Y wrote in a letter dated May 4, that was
included in the PCAOB report.

Firm (Ernst & Young) failed to identify a
material weakness in the issuer's internal controls over the accounting for
sales returns.

Issuer B
In this audit, the Firm failed to identify a departure from GAAP that it
should have identified and addressed before issuing its audit report. The
issuer failed to appropriately account for estimated future product returns
at the time of sale in accordance with SFAS No. 48.

Issuer C
In this audit, there was no evidence in the audit documentation, and no
persuasive other evidence, that the Firm had identified certain terms and
conditions contained in the issuer's revenue contracts and evaluated their
effect on the issuer's ability to report revenue on a gross basis. Further,
there was no evidence in the audit documentation, and no persuasive other
evidence, that the Firm had identified and evaluated certain other terms and
conditions included in these contracts, such as multiple products and
deliverables, acceptance clauses, guarantees of cost savings, and volume
rebates, that may have affected the issuer's revenue recognition.

Issuer D
During the fourth quarter, the issuer recorded three individually
significant adjustments to correct misstatements in its income tax balances.
Two of these misstatements related to prior years. The third related to the
issuer's first quarter adoption of Financial Accounting Standards Board
Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN
48"). The issuer corrected all three misstatements, which netted to an
insignificant amount, by adjusting the current year's income tax expense.
The Firm concluded that two of the adjustments should have been recorded as
corrections of prior years' errors and the third adjustment should have been
recorded as a charge to retained earnings as of the beginning of the year
under audit. The Firm also concluded that the net effect of the
misstatements was not material to either the current year's or the prior
year's financial statements.

In evaluating the net effect of the misstatements,
the Firm failed to sufficiently quantify and evaluate one of the
misstatements, which related to the income tax valuation allowance. The
Firm's analysis both excluded a significant tax asset and relied on
information that the issuer had deemed to be unreliable for the purpose of
estimating the income tax valuation allowance because the use of the
information by the issuer in the past had produced results that were not
accurate. Further, the Firm did not evaluate the effect of this misstatement
on prior years because it assumed that all amounts related solely to the
preceding year, despite evidence to the contrary. Finally, concerning one of
the other misstatements, the Firm failed to evaluate the materiality of the
FIN 48 adjustment, which represented almost 75 percent of the initial FIN 48
liability recorded in the first quarter, against the cumulative effect of
the accounting change.

Issuer E
In this audit, the Firm failed in the following respects to obtain
sufficient competent evidential matter to support its audit opinion –

• The Firm failed to perform sufficient
procedures to assess the valuation of certain securities. Specifically,
there was no evidence in the audit documentation, and no persuasive
other evidence, that the Firm had sufficiently evaluated whether certain
of the assumptions underlying the issuer's valuation of the securities
were reasonable, and not inconsistent with information that would be
used by other market participants to value these types of securities.
While the Firm obtained certain historical information, the Firm did not
analyze how this historical information provided evidence on the
reasonableness of the issuer's assumptions.

The Firm failed to perform sufficient
procedures to assess the valuation of certain of the issuer's loans in
the following respects – o To determine the values of certain loans, the
issuer used prices from certain recent transactions. There was no
evidence in the audit documentation, and no persuasive other evidence,
that the Firm had evaluated whether the loans being valued were of
comparable quality to the loans included in the transactions.

For other loans, the Firm developed an
independent estimate of the value. The Firm's independent estimate
was not appropriately supported, as it was based on the incorrect
premise that the transactions to which the Firm looked for certain
of the inputs were comparable to transactions that would involve the
loans being valued

Issuer F
With respect to a significant portion of the issuer's revenue, the Firm
failed to test the issuer's vendor-specific objective evidence of the value
of deliverables offered in multiple-element arrangements in order to
determine whether the amount of revenue that was recognized for individual
elements was reasonable. Further, regarding revenue cut-off, the Firm noted
that, in the year under audit and the preceding year, revenue significantly
increased during the final month of each quarter and at year end.
Nonetheless, other than obtaining a list of all contracts, including any
changes made to existing contracts, the Firm's substantive procedures to
test sales cut-off were limited to analytical procedures that failed to
provide the necessary level of assurance because the Firm did not establish
expectations for the procedures. Issuer G In this audit, in evaluating the
issuer's reserve analysis for two impaired loans, the Firm failed to perform
procedures, beyond management inquiries, to evaluate the appropriateness of
the methods and the reasonableness of the assumptions that the issuer and
certain specialists engaged by the issuer used in estimating the fair value
of certain assets that collateralized the loans. Issuer H The issuer
amortized certain of its intangible assets on a straight-line basis over the
estimated useful lives of the assets. The Firm failed to evaluate whether
the issuer's use of the straight-line basis was appropriate given evidence
that the economic benefit of the intangible assets was expected not to be
consumed at the same rate throughout the assets' lives.

In addition to evaluating the quality of the audit
work performed on specific audits, the inspection included review of certain
of the Firm's practices, policies, and processes related to audit quality.
This review addressed practices, policies, and procedures concerning audit
performance and the following five areas (1) management structure and
processes, including the tone at the top; (2) practices for partner
management, including allocation of partner resources and partner
evaluation, compensation, admission, and disciplinary actions; (3) policies
and procedures for considering and addressing the risks involved in
accepting and retaining clients, including the application of the Firm's
risk-rating system; (4) processes related to the Firm's use of audit work
that the Firm's foreign affiliates perform on the foreign operations of the
Firm's U.S. issuer audit clients; and (5) the Firm's processes for
monitoring audit performance, including processes for identifying and
assessing indicators of deficiencies in audit performance and processes for
responding to weaknesses in quality control. Any defects in, or criticisms
of, the Firm's quality control system are discussed in the nonpublic portion
of this report and will remain nonpublic unless the Firm fails to address
them to the Board's satisfaction within 12 months of the date of this
report.

The
Supreme Court Puts Sarbanes-Oxley and the PCAOB on the Chopping
Block

Here's a pleasant surprise: The
Supreme Court agreed yesterday to hear arguments in a case
challenging the constitutionality of the Sarbanes-Oxley Act of
2002. This could get interesting.
"Sarbox and the Constitution," The Wall Street Journal,
May 19, 2009 ---
http://online.wsj.com/article/SB124268754900032175.html
Jensen Comment

This is a pleasant
surprise for CEOs who do not want to take responsibility for
internal controls in their companies and for companies that want
weaker and cheaper financial audits. It is not a pleasant
surprise for auditing firms. It could return auditing to the
1990s when audits became unprofitable commodities.

This
could be a disaster to auditing firm revenues. Hopefully the
Supreme Court will instead lock in SOX for the smelly feet of
unscrupulous corporations. It also could badly hurt the recovery
of the stock market since investors will have less confidence in
the integrity of financial statements.

The poor services of
auditing firms became a focal point in the U.S. Congress when
equity markets appeared of the verge of collapse due to fear and
distrust of the financial reporting of corporations dependent
upon equity markets for capital. The Roaring 1990s burned and
crashed. In a desperation move Congress passed the
Sarbanes-Oxley Act (SOX) of 2002 --- http://en.wikipedia.org/wiki/Sarbanes-Oxley_Act

SOX was a shot in the
arm for the auditing industry. SOX forced the auditing industry
to upgrade services with SOX legal backing that doubled or even
tripled or quadrupled fees for such services. Clients continue
to grumble about the soaring costs of audits, but in my opinion
SOX was a small price to pay for saving our equity capital
markets.

As of 31 May 2009, 3,164,828
Deloitte IFRS e-learning modules have been downloaded by visitors to IAS
Plus. During 2008 alone, 1,070,387 modules were downloladed.
Deloitte's IFRS e-learning was launched at the end of January 2004. Many of
the downloaded modules have multiple users because organisations are
permitted to install them on their own servers for the internal use of their
employees or students. These figures do not include modules completed by
Deloitte staff, who access the e-Learning on internal networks. You can
always access IFRS e-Learning without charge by clicking on the light bulb
icon on the IAS Plus home page. Thirty-seven modules are now available and
regularly updated. We are making the
Deloitte IFRS e-Learning available in the public interest without charge.

Somewhere in this discussion someone mentioned that
there were roughly 100 foreign companies who trade in the U.S. that have
chosen to adopt IFRS this year. Is there a source for that information?
Also, about how many foreign companies trade here (to get an idea if 100 is
"a lot" or not)? I am interested in the reasons why (or not) IFRS is chosen.

Thanks for the help.

Best,

Robert Pinsker Ph.D., CPA
Associate Professor of Accounting
Old Dominion University

I believe I'm the one that mentioned this because
I'm working on a project where I need this information. Unfortunately, at
the present time, there is no one source (to my knowledge).

One simply starts non-US companies listed on either
NYSE or NASDAQ. The NYSE makes do this somewhat easier than NASDAQ.

First, you narrow the companies to those that use
Form 20-F (rather than 10-K which means the company definitely uses US GAAP
and meets all other reporting and disclosure requirments for a US issuer).
Then, you look at the financial statements one at a time to identify if they
report under IFRS or some other GAAP (potentially US GAAP) and whether or
not the audit report agrees with the company's statement of compliance with
IFRS.

There are far more foreign private issuers that
trade in the US. I haven't attempted to count or codify them. Some companies
have several different types of securities listed which makes a simple count
difficult. If you are really interested, you can go to the NYSE website,
listing directory for the NYSE, and then to non-US listed companies.

Abstract:
Managers sometimes implement accounting standards (such as the lease
standard) opportunistically to move debt off balance-sheet. Regulators are
under pressure to adopt principles-based accounting standards to reduce such
opportunism. However, there are lingering concerns about whether
principles-based standards can be properly implemented and enforced. We
report results of an experiment where highly experienced financial managers,
with incentives to structure a transaction off balance sheet, take a
reporting position on how a lease is to be disclosed. We manipulate the type
of GAAP (principles-based, rules-based) and the type of auditor
(client-oriented, principles-oriented, or rules-oriented). Our results show
that when the auditor is client-oriented, the nature of GAAP does not
matter, and that a move towards more principles-based standards is likely to
result in improved financial reporting quality only when there is a
corresponding shift in auditors' mindsets towards beings more
principles-oriented.

Are accounting internal controls at universities lax?

"This person was a dean," says Ms. Willihnganz, the
provost. "And deans here have a very wide breadth of control. They have a lot of
authority. I think, in fact, no one else here at this university could have
gotten some of those things through. Because he was a dean, he was trusted."

At the end of 2005, Robert D. Felner was riding
high. A well-paid dean at the University of Louisville, he had just secured
a $694,000 earmarked grant from the U.S. Department of Education to create
an elaborate research center to help Kentucky's public schools.

The grant proposal, which Mr. Felner had labored
over for months, made some impressive promises. Five Louisville faculty
members would devote time to the center, and four other people would be
hired. The advisory board would be led by Virginia G. Fox, Kentucky's
secretary of education.

On paper this all seemed plausible: From 1996 until
2003, Mr. Felner directed the University of Rhode Island's education school,
where he helped create a well-regarded statewide research center.

To put it gently, Mr. Felner did not duplicate that
feat at Louisville.

By the spring of 2008, all but $96,000 of the grant
had been spent, but none of the tasks listed in Mr. Felner's proposal had
been accomplished. Hundreds of thousands of surveys of students, teachers,
and parents? School officials in Kentucky say they know of no such studies.
Conferences and special issues of education journals? None. An advisory
committee led by the state's top education officials? They say they never
heard of Mr. Felner's center.

At this point, Mr. Felner was heading for the exit,
continuing his climb up the academic ladder. Late in May 2008, he told his
colleagues that he had been hired as chancellor of the University of
Wisconsin-Parkside, effective August 1.

During his final weeks at Louisville, Mr. Felner
pressed his luck one last time. Even though only $96,000 remained in the
account, he implored Louisville officials to approve a $200,000 subcontract
with a nonprofit organization in Illinois that had already received $450,000
from the grant. Perhaps, he suggested, the university could draw on a
special fund that had been established by the daughter of a former trustee.

The Illinois group, Mr. Felner said, had been
surveying students and teachers in Kentucky. That survey would "let us give
the feds something that should make them very happy about the efficiency and
joint commitment of the university to doing a good job with an earmark, as I
know we will want more from this agency," he wrote in an e-mail message on
June 18.

Two days later, Mr. Felner's offices were raided by
federal agents who took away his files and laptops. He was questioned for
hours by a U.S. Postal Service inspector and a member of the University of
Louisville's police department. That weekend he called Wisconsin officials:
Sadly, he wouldn't be coming to Parkside after all.

In October a federal grand jury indicted Mr. Felner
on nine counts of mail fraud, money laundering, and tax evasion. According
to the indictment, the Illinois nonprofit group, known as the National
Center on Public Education and Prevention, was simply a shell that funneled
money into the personal bank accounts of Mr. Felner and Thomas Schroeder, a
former student of his and the group's "executive director." Prosecutors say
the two men siphoned away not only the $694,000 earmarked grant, but also
$1.7-million in payments from three urban school districts, money that ought
to have gone to the legitimate public-education center that Mr. Felner had
created in Rhode Island.

Mr. Felner and Mr. Schroeder now await trial on
charges that could send them to prison for decades. No trial date has been
set.

None of the accusations have been proved in court,
and Mr. Felner's lawyers have signaled in pretrial briefs that they will
defend him aggressively. (They declined to comment for this article.)

But two facts seem hard to avoid: All but $96,000
of the earmarked grant has been spent. And there is no evidence that the
activities listed in Mr. Felner's grant proposal have been carried out.

A Question of Oversight

When Louisville accepted the earmarked grant, its
officials signed the boilerplate language attached to most federal
contracts. The university, they promised, had "the institutional,
managerial, and financial capability ... to ensure proper planning,
management, and completion of the project."

But did it in fact have that capability? For
several months in 2007, Mr. Felner charged almost $37,000 of his salary
against the grant, but there is no evidence that he ever worked on the
project. (In an October 2008 memorandum, Robert N. Ronau, the college of
education's associate dean for research, declared that he knew of no
reports, articles, or other products that resulted from the grant.). Federal
regulations require that universities use "suitable means of verification
that the work was performed" when they prepare time-and-effort reports;
Louisville officials declined to comment on how Mr. Felner's time-and-effort
reports were processed.) And when he sent his first big payment to the
Illinois group, Mr. Felner constructed the deal as a personal-services
contract instead of a formal subcontract, which would have been subject to
more oversight by the university. But no one corrected that error for more
than a year.

In the months since Mr. Felner's indictment,
Louisville has seen a parade of blue-ribbon committees, auditors, and
management consultants. University leaders insist that they have streamlined
their research-compliance systems to prevent any more trouble. They also
emphasize that it was a university employee who tipped off law enforcement
to Mr. Felner's actions. (Who did this and when remains a mystery — but
e-mail records obtained by The Chronicle make clear that by May 2008,
Louisville's research administrators were becoming more openly skeptical of
Mr. Felner's claims.)

"What these reports have affirmed is that we
basically have pretty good practices in place," says Shirley C. Willihnganz,
Louisville's provost. "I think what we had in this case was a person who
abused the system. And so it's not so much that our policies were bad or
that our procedures were bad. We had a person who did not follow them and
did not respect them."

But some of Mr. Felner's former colleagues insist
that he should have been stopped long before the spring of 2008. They say
the university coddled Mr. Felner and turned a blind eye to his grant
management, in part because the doctoral program in education rose
impressively in the annual U.S. News & World Report rankings after his
arrival. If the university had paid more attention to the many faculty and
student grievances against Mr. Felner — and especially to a 2006 faculty
vote of no confidence in his leadership — the grant money might never have
gone missing, they say.

"The University of Louisville, like everybody, is
aspiring to bring in more grant dollars," says Bryant A. Stamford, a
professor of exercise science at Hanover College who left Louisville's
faculty in 2005 after a dispute with Mr. Felner. "When you put yourself in
that position, it's pretty amazing what you're willing to do. You sacrifice
the infrastructure of the university in order to put out a report that says,
Look, grants are up by 60 percent this year."

The Louisville affair comes at a time when
officials of Emory University, Harvard University, and other institutions
have faced Senate investigations revealing that scholars had failed to
disclose hundreds of thousands of dollars they had received from
pharmaceutical companies. Throughout the country, research administrators
are asking themselves if tougher rules could detect miscreants, or whether
determined liars will always find a way around the rules.

Throwing a Bone

In 2005, two years after he arrived at Louisville,
Mr. Felner won his $694,000 earmarked federal grant, which was billed as
"Support and Continuous Improvement of No Child Left Behind in Kentucky."

The earmark was sponsored by U.S. Representative
Anne M. Northup, a Republican who then represented Kentucky's third
district. It is easy to see what might have attracted Ms. Northup to Mr.
Felner's proposal: He claimed to have lined up cooperation from a host of
Kentucky school districts and public officials, and he could point to the
track record of his Rhode Island center.

In fact, the proposal promised not only to
replicate the success of Mr. Felner's Rhode Island center. It promised to
bring the Rhode Island center to Louisville. The National Center on Public
Education and Social Policy was "formerly located at the University of Rhode
Island" and would "now be subsumed under the aegis of" Mr. Felner's
Louisville office, the proposal said.

So maybe it should have raised eyebrows among
Louisville's research administrators when in March 2006, only a few months
after he had won the earmark, Mr. Felner sent $60,000 of the grant money to
Rhode Island.

The "work plan" attached to that subcontract was a
blizzard of verbiage that said nothing very specific about what the Rhode
Island center was supposed to do with the $60,000. "The National Center on
Public Education and Social Policy at the University of Rhode Island agrees
to provide data analysis and support relating to critical questions and
educational research issues focused on No Child Left Behind Initiatives for
project work conducted by the University of Louisville," the plan read. "By
subcontracting with the University of Rhode Island, the NCLB Center can
begin work immediately with data collected by the Center. URI's established
level of expertise and technological capabilities are sophisticated enough
to assimilate endeavors of this magnitude seamlessly while the Center is in
the process of building their systems and personnel."

The $60,000 actually had nothing to do with Mr.
Felner's earmark, according to federal prosecutors and officials at Rhode
Island. Instead, they say, Mr. Felner was throwing a bone to his former
colleagues, whom he and Mr. Schroeder had cheated out of more than
$1.7-million in income.

Here we need to make a quick detour into the heart
of the prosecutors' allegations. Between 2000 and 2003, the Rhode Island
center conducted tens of thousands of surveys in public schools in Atlanta,
Buffalo, and Santa Monica. But Mr. Felner and Mr. Schroeder allegedly
tricked the three districts into sending their payments to their fraudulent
Illinois organization, whose name was very similar to the Rhode Island
center's. (In Rhode Island: the National Center on Public Education and
Social Policy. In Illinois: the National Center on Public Education and
Prevention.) The Illinois money then flowed into the two men's bank
accounts, prosecutors say. Mr. Felner owns four houses whose combined value
is more than $2-million.

Stephen Brand, a professor of education at Rhode
Island who worked on the three survey projects, says that Mr. Felner strung
the center along with vague promises and explanations about why the school
districts' money had not materialized. But Mr. Brand says he does not know
many details. "I haven't seen copies of those three contracts," he says. "I
don't think anyone here has ever seen them." (Anne Seitsinger, the Rhode
Island center's director, declined repeated requests for an interview.)

In any case, the Rhode Island center managed to
survive for several years without the $1.7-million because it had
accumulated a substantial surplus from its multiyear, multimillion-dollar
survey contract with the state of Rhode Island. But by 2005 it was facing a
deficit. That year, according to The Providence Journal, the center's
business manager wrote to Mr. Felner in Louisville: "Are you giving out
loans? We sure need one right now."

The $60,000 subcontract was apparently just such a
"loan." The money was used only to cover the Rhode Island center's operating
deficit. Despite its purported power to "assimilate endeavors of this
magnitude seamlessly," the Rhode Island center never actually did any work
on the earmarked Louisville grant.

Robert A. Weygand, Rhode Island's vice president
for administration, concedes that it was wrong for the center to accept the
$60,000, and he says the university has tightened the oversight of all its
research centers. But he emphasizes that federal prosecutors have not
charged anyone at Rhode Island with any crime. "What they've told us is that
we're a victim of a million-dollar theft," Mr. Weygand says. "We have a
right to compensation from any funds that may be recovered from Mr. Felner.
We've been working with the Secret Service."

Budget Details

The $60,000 Rhode Island subcontract was only a
prelude. At the end of 2006, Mr. Felner told his colleagues that Louisville
needed to sign a $250,000 personal-services contract with the Illinois
center. His grant proposal had said nothing about the Illinois center, but
Mr. Felner now declared that that center, as the "developer/owner of the
High Performance Learning Communities Assessments," was the only entity that
could effectively survey students and teachers in Kentucky. At the end of
2007, he sent another $200,000 to Illinois. According to prosecutors, the
entire $450,000 eventually ended up in Mr. Felner's and Mr. Schroeder's
wallets.

Where the work plan on the Rhode Island subcontract
had been flowery and vague, the work plans on the Illinois subcontracts were
curt and vague. The first one said only that the Illinois center would
"provide for the use" of the survey assessments "and the use of data derived
therefrom." The second one said that the Illinois center would provide
survey data from 135,000 students, 50,000 parents, and 10,500 teachers — but
it did not name any Kentucky school districts where the surveys would be
conducted.

E-mail records offer a detailed tracing of how that
second Illinois subcontract was constructed. The process suggests how Mr.
Felner tended to parry research administrators' efforts — such as they were
— to wring accurate information from him.

On November 9, 2007, Jennifer E. Taylor, director
of grant support and sponsored programs at the college of education, wrote
to Mr. Felner to report that she had spoken with B. Ann LaPerle, an
assistant in the university's office of grants management. "I just spoke
with Ann about the subcontract with Tom [Schroeder]'s group," Ms. Taylor
wrote. "We are going to need a detailed budget, so if you have time today,
we can get this out and processed."

Mr. Felner replied with a small tantrum. "I have no
idea what that means but will try as we have never done such a thing," he
wrote. "We tend to pay them by the number of students and surveys but since
we do not have enough to actually pay for it all so they are giving us some
for free this could be tricky. And given the delays already if it takes
another week or so we simply will not be able to do it this year nor finish
the work. Unbelievable!"

Later that day, Ms. Taylor wrote to Ms. LaPerle,
instructing that the subcontract's detailed budget should read simply "$1
per survey for 200,000 surveys."

But hours later, Mr. Felner weighed in with a more
detailed budget — the one that ultimately appeared on the subcontract. Mr.
Felner's version stipulated 135,000 student surveys at a price of $1.25
each, 10,500 teacher surveys at $1.45 each, and so on through several more
categories.

Apparently no one questioned the discrepancy
between the two versions. And neither Ms. LaPerle nor Ms. Taylor asked for
any proof that the Illinois center had done any work on its first
subcontract, which had been signed almost a year earlier.

It is that last element that seems most startling.
It must have been an open secret in Ms. Taylor's office that the Illinois
group had received $250,000 at the beginning of 2007 but that no surveys had
been conducted. Ms. Taylor has left the university. Her supervisor, Mr.
Ronau, declined requests for an interview.

So why did Louisville officials not catch this
apparent fraud for a full two years? The Rhode Island subcontract said the
center was supposed to submit a final report by the end of September 2006,
but no report was ever submitted. The Illinois contracts likewise specified
report dates, and one of them said that its work would require approval by a
human-subjects-protection board. None of that ever happened — but there is
no evidence that anyone objected before the spring of 2008.

"This person was a dean," says Ms. Willihnganz, the
provost. "And deans here have a very wide breadth of control. They have a
lot of authority. I think, in fact, no one else here at this university
could have gotten some of those things through. Because he was a dean, he
was trusted."

Misplaced Trust

But that is exactly what many of Mr. Felner's
former colleagues dispute. Louisville's leaders, they say, had plenty of
reason to distrust Mr. Felner long before he began to send six-figure checks
to Illinois.

Continued in article

Kansas State U. Audit Finds Possible Financial ShenanigansAn audit released Friday by the Kansas State Board of
Regents has found thousands of dollars worth of payments to companies owned by
current and former university officials,The Kansas City
Staris reporting. The officials include Bill
Snyder, the football coach; Tim Weiser, a former athletic director; and Robert
S. Krause, a former vice president for institutional advancement and former
athletic director. The 34-page
audit,which describes other poor accounting and
possible IRS problems for the university, is part of
an exit review by the Board of Regents of Kansas State’s former president, Jon
Wefald, who left this year.
Heidi Landecker, Chronicle of Higher Education, June 20, 2009 ---
http://chronicle.com/news/article/6673/kansas-state-u-audit-finds-questionable-payments-to-officials

BDO International is not liable for $351 million in punitive damages that a
Miami jury awarded a Portuguese bank in 2007, a Miami-Dade Circuit judge has
ruled.

Banco Espirito Santo was awarded $170 million for its losses and $351
million in punitive damages for the negligence of accounting firm BDO
Seidman. The reason: BDO failed to uncover fraud at a now-defunct financial
services firm in which the bank held a stake. Still left to be decided is
whether BDO International is on the hook for the $170 million award, too.

TRIAL UNDER WAY

In a trial now under way in Miami-Dade Circuit, Banco Espirito Santo had
wanted a new jury to hold BDO International responsible for the 2007 award,
as well. The bank alleged BDO International was grossly negligent in failing
to ensure Chicago-based BDO Seidman performed proper audits of factoring
firm E.S. Bankest.

Belgium-based BDO International was part of the earlier trial, but was
dismissed from the case after a judge found the bank presented no evidence
establishing its claim against BDO International. An appeals court disagreed
and ordered that a jury must decide whether BDO International was
responsible for ensuring the quality of BDO Seidman's audits.

Article continues

QUESTION FOR JURY

Still left for the jury to decide is whether BDO International should be
responsible for the $170 million in losses sustained by the bank because of
the fraud. The bank alleges BDO International is liable for the verdict
because BDO Seidman is an agent of BDO International. BDO Seidman has
appealed the verdict.

On Tuesday, BDO International completed the presentation of its case.
Closing arguments in the trial, which started two weeks ago, may happen on
Wednesday.

Document MHLD000020090617e56h0000o

From The Wall Street Journal Accounting Weekly
Review on June 18, 2009

SUMMARY: "Seven
people including the former chief executive and chairman of accounting firm
BDO Seidman LLP have been charged criminally in an allegedly fraudulent
tax-shelter scheme that generated billions of dollars in false tax losses
for clients." The remaining six include three former Jenkens & Gilchrist PC
lawyers--one of which is Paul Daugerdas, former head of the law firm's
Chicago office who joined the firm bringing in the revenue from these
tax-structured transactions--and two former investment-bank employees. The
investment bank wasn't named in the indictment but "a person familiar with
the matter" said it was Deutsche Bank AG.

CLASSROOM APPLICATION: Ethics,
including the need to stand up against others' unethical actions, can be
discussed with this article.

QUESTIONS:
1. (Introductory)
What is tax evasion? Differentiate it from tax avoidance.

2. (Advanced)
What types of firms have been charged in this "27-count federal indictment,
which includes charges of conspiracy and tax evasion"? How must these types
of firms work together to structure tax-beneficial transactions?

3. (Introductory)
Refer to the related articles. Summarize the description of the types of
transactions questioned by the IRS and leading to the indictment.

4. (Advanced)
Are there ways in which structured transactions can be legitimate tax
shelters? What are some general requirements that must be met for a
transaction to be considered legitimate?

5. (Introductory)
Refer again to the related articles. What were the Jenkens & Gilchrist
partners' concerns about the risk of the transactions and services
structured and sold by the Chicago office partner Mr. Daugerdas? What
factors did they allow to override their concerns?

6. (Introductory)
Place yourself in the position of partner in the law firm of Jenkens &
Gilchrist. Consider the issues discussed at the board meetings in offering a
position to Mr. Daugerdas and in dealing with the beginning lawsuits from
clients facing IRS scrutiny. How would you react in each of these meetings?

7. (Advanced)
What is the affiliation of the accounting firm BDO Seidman in these
transactions? How could the accounting firm and its partner be held
responsible for a transaction designed by another firm--a law firm, not an
accounting firm, at that?

Adrian Dicker, a United
Kingdom chartered accountant and former vice chairman and board
member at a major international accounting firm, has pleaded guilty
to conspiring with certain tax shelter promoters to defraud the
United States in connection with tax shelter transactions involving
clients of the accounting firm and the law firm Jenkens & Gilchrist
(J&G), the Justice Department and Internal Revenue Service (IRS)
announced. In the hearing before U.S. Magistrate Judge Theodore H.
Katz in the Southern District of New York, Dicker, who is a resident
of Princeton Junction, NJ, also pleaded guilty to tax evasion in
connection with a multi-million dollar tax shelter that Dicker
helped sell to a client of the accounting firm.

According to the
information and the guilty plea, between 1995 and 2000, Dicker was a
partner in the New York office of the accounting firm which he
identified during his guilty plea as BDO Seidman. From early 1999
through October 2000, Dicker was on the firm's Board of Directors,
and through October 2003 he served as a retired partner director.
From 1998 until 2000, Dicker was one of the leaders of the firm's
"Tax Solutions Group" (TSG), a group led by the firm's chief
executive officer, Dicker, and another New York-based tax partner.
The activities of the TSG were devoted to designing, marketing, and
implementing high-fee tax strategies for wealthy clients, including
tax shelter transactions.

According to the
information and the guilty plea, Dicker and the other two TSG
managers used a bonus structure that handsomely rewarded the
accounting firm personnel involved in the design, marketing, and
implementation of the TSG's transactions, including: the individual
who referred the client to TSG personnel; the TSG member who pitched
and closed the sale; other TSG members; and TSG management. From
July 1999, Dicker, the CEO, and the other TSG manager earned and
shared equally 30 percent of the net profits of the TSG. Dicker
earned approximately $6.7 million in net TSG profits, as well as
salary and bonuses between 1998 and 2000. In addition, the CEO of
the firm doled out additional bonuses from the profits earned as a
result of the sale of the tax shelter products. Moreover, the firm
made the sale of the tax shelter products a focal point of its
aggressive "value added" product promotion activities, using a "Tax
$ells" logo and other marketing hype to induce employees to generate
additional tax shelter sales.

According to the
information and the guilty plea, while serving as a manager of the
TSG, Dicker, along with other TSG partners, engaged in the design,
marketing, and implementation of two different tax shelter
transactions with the Chicago office of the law firm of Jenkens &
Gilchrist, as well as an international bank with its U.S.
headquarters in New York. As a member of TSG and the accounting
firm's tax opinion committee - which reviewed the tax opinions
issued in connection with tax shelter transactions sold by the
accounting firm and J&G - Dicker knew that the tax shelter
transactions he helped vet and sell would be respected and allowed
by the IRS only if the client had a substantial non-tax business
purpose for entering the transaction, and the client had a
reasonable possibility of making a profit through the transaction.
Dicker and his co-conspirators knew and understood that the clients
entering into the tax shelter transactions being marketed and sold
with J&G had neither a substantial non-tax business purpose nor a
reasonable possibility of earning a profit, given the large amount
of fees being charged by the accounting firm and J&G to enter the
transaction. Those fees were set by the co-conspirators as a
percentage of the tax loss being sought by the tax shelter clients.
Dicker also knew that the clients who purchased the tax shelter had
no non-tax business reasons for entering into the transactions and
their pre-planned steps.

According to the
information and the guilty plea, in order to make it appear that the
tax shelter clients of Dicker, other TSG members, and J&G had the
requisite business purpose and possibility of profit, Dicker and his
co-conspirators reviewed and approved the use of a legal opinion
letter issued by J&G that contained false and fraudulent
representations purportedly made by the clients about their
motivations for entering into the transactions. In addition, Dicker
and his co-conspirators created and used, or approved of the
creation and use of, other documents in the transactions that were
false, fraudulent, and misleading in order to paint a picture for
the IRS that was patently untrue - that is, that the clients had a
legitimate non-tax business purpose for entering the transaction and
executing the preplanned steps of the transaction. Dicker also
admitted during his plea that TSG members created and placed into
client files certain paperwork that falsely conveyed fabricated
business purposes and rationales for clients entering into the
shelters. The false paperwork was created to mislead and defraud the
IRS.

Q: I find your Tech Q&A column very useful. Is
there some way I can track down items you published earlier? It sure would
be handy.

A: Several readers have asked about this, and yes,
the magazine has a very comprehensive and easy-to-use Web site for locating
articles. Go to
www.journalofaccountancy.com/BrowseTopics , and
then cursor down to the “Technology” area and then to “Tech Tips.” The Web
site also has a very powerful search engine for tracking down articles by
subject, author, headline and more.

"Kmart officials as purposely violating accounting principles
with the knowledge of the company's auditors,
PricewaterhouseCoopers."

The former head of Kmart Corp., who told jurors he
was hired to save the venerable retailer, was found liable Monday for
misleading investors about company finances before a bankruptcy filing in
2002.

The verdict in the civil fraud trial followed 10
days of testimony in federal court in Ann Arbor. The case was a fresh look
at Charles Conaway's brief tenure and the desperate scramble to keep Kmart
afloat before one of the largest bankruptcies in retail history.

The Securities and Exchange Commission accused him
of failing to disclose that the retailer was delaying payments to suppliers
to save cash. The trial centered on a conference call with analysts and
Kmart's quarterly report to regulators, both in November 2001.

"It was a clean sweep," SEC trial lawyer Alan
Lieberman said of the verdict.

"It is never enough for the numbers to be right.
For the average investor, the numbers being right do not tell the whole
story," he said. "They need to know the material information that management
knows. The foundation of the markets is full and honest disclosure."

The SEC blamed Conaway for not sharing details in
the report's management-analysis section. He testified that he didn't write
it, didn't read it and relied on his chief financial officer and others.

During a call with Wall Street analysts, Conaway
said sales were poor - and the stock took a 15 percent hit - but he didn't
talk about the vendor strategy or an ill-timed purchase of $800 million in
merchandise.

He testified that Kmart had $1 billion in cash and
credit when the call was made and the quarterly report was filed. Conaway
said it "never" crossed his mind that he was withholding critical news.

The jury, however, found that he acted "with intent
to defraud or with reckless disregard for the truth."

Despite Conaway's testimony, the jury found that
delaying payments to vendors was a "material liquidity deficiency" affecting
Kmart's finances and should have been publicly reported.

Conaway's lawyer, Scott Lassar, said they were
disappointed with the verdict and would pursue an appeal.

U.S. Magistrate Judge Steven Pepe will handle the
penalty phase. Conaway, 48, could be fined and banned from serving as an
executive or director at a public company.

He had a successful career in the drugstore
industry when he agreed in 2000 to try to turn around Kmart, which was no
match for discount rivals Wal-Mart Stores Inc. and Target Corp. Conaway was
gone less than two years later.

Kmart emerged from Chapter 11 bankruptcy as a
smaller company and now is part of Sears Holdings Corp., based in Hoffman
Estates, Ill.

The lawsuit against Conaway and his former CFO,
John McDonald Jr., was filed in 2005, three years after the bankruptcy.

Ronald Kiima, formerly an assistant chief
accountant at the SEC, said when a company fails "there's a lot of `What did
you know and when did you know it?'"

"If you don't give the sausage-making of what
happened during a quarter, that could be an issue," Kiima said in an
interview. "For a CEO to say he didn't lay eyes on the report is pretty
damning."

Continued in article

Jensen Comment
Discount retailer Kmart came under investigation for irregular accounting
practices in 2002. In January an anonymous letter initiated an internal probe of
the company's accounting practices. The Detroit News obtained a copy of
the letter that contains allegations pointing to senior Kmart officials as
purposely violating accounting principles with the
knowledge of the company's auditors, PricewaterhouseCoopers.
http://www.accountingweb.com/item/82286

Bankrupt retailer Kmart explained the
impact of accounting irregularities and said employees involved in questionable
accounting practices are no longer with the company.
http://www.accountingweb.com/item/90935

Kmart's CFO
Steps up to Accounting Questions

AccountingWEB
US - Sep-19-2002 - Bankrupt retailer Kmart explained the
impact of accounting irregularities in a Form 10-Q filed with the
U.S. Securities and Exchange Commission (SEC) this week. Chief
Financial Officer Al Koch
said several employees involved in questionable accounting
practices are no longer with the company.

Speaking to
the concerns about vendor allowances recently raised in anonymous
letters from in-house accountants, Mr. Koch said, "It was not hugely
widespread, but neither was it one or two people."

The Kmart
whistleblowers who wrote the letters said they were being asked
to record transactions in obvious violation of generally accepted
accounting principles. They also said "resident auditors from
PricewaterhouseCoopers are hesitant to pursue these issues or even
question obvious changes in revenue and expense patterns."

In response
to the letters, the company admitted it had erroneously accounted
for certain vendor transactions as up-front consideration, instead
of deferring appropriate amounts and recognizing them over the life
of the contract. It also said it decided to change its accounting
method. Starting with fourth quarter 2001, Kmart's policy is to
recognize a cost recovery from vendors only when a formal agreement
has been obtained and the underlying activity has been performed.

According
to this week's Form 10-Q, early recognition of vendor allowances
resulted in understatement of the company's fiscal year 2000 net
loss by approximately $26 million and overstatement of its fiscal
year 2001 net loss by approximately $78 million, both net of taxes.
The 10-Q also said the company has been looking at historical
patterns of markdowns and markdown reserves and their relation to
earnings.

Kmart is
under investigation by the SEC and the Justice Department. The
Federal Bureau of Investigation, which is handling the investigation
for the U.S. Attorney, said its investigation could result in
criminal charges. In the months before Kmart's bankruptcy filing,
top executives took home approximately $29 million in retention
loans and severance packages. A spokesperson for PwC said the firm
is cooperating with the investigations.

Companies have long flocked to low-tax locales like
Delaware and South Dakota. But those tax advantages may soon be in jeopardy.
States, which collectively could face a $50 billion budget shortfall over
the next two years, are scrambling for cash and may start hitting up
companies for more money—even companies outside their borders. "The states
are turning over every rock for money," says Richard D. Pomp, a professor at
the University of Connecticut School of Law. "If they haven't been looking
at the issue, they will."

Massachusetts officials just got the green light
from the state's highest court to collect taxes from a multitude of
companies headquartered elsewhere. Last year the state moved to collect more
than $2 million in taxes from credit-card giant Capital One Financial (COF).
The state claimed that Cap One made a sizable chunk of money from
cardholders who reside there, and so the company had to fork over taxes on
the income.

Cap One balked, taking the matter to the state's
Appellate Tax Board. The company's argument: It didn't have a branch or an
office in the state, the traditional standard for collecting corporate
income tax. Cap One lost the case and a subsequent appeal to the
Massachusetts Supreme Judicial Court in March. "The uncertainty and burden
of trying to comply with state-by-state standards creates a significant
hardship for businesses trying to navigate the economic consequences of
their decisions," says Ryan Schneider, president of card services for Cap
One.

Cap One is petitioning the U.S. Supreme Court to
hear the case. If the nation's top court takes up the matter—and rules in
the company's favor—it could halt the momentum nationwide to tax
out-of-state companies. But the U.S. Supreme Court may not be sympathetic to
Cap One. The justices refused to review a similar case in 2007 involving
MBNA (BAC), now owned by Bank of America (BAC). Indiana courts decided the
credit-card issuer owed taxes on fees and interest paid by local
cardholders. Like Cap One, MBNA didn't have an office in the state. The
differences between the two cases aren't meaningful, explains Washington
(D.C.) attorney Donald M. Griswold, who represented MBNA in the matter.
That's why, he says, "there's a snowball's chance in hell" the Supreme Court
will hear Cap One's case.

The credit-card industry isn't the only one facing
a bigger tax bill if more states follow Massachusetts' lead. Tax experts and
lawyers figure states also may go after insurers, online retailers, software
makers, and other companies that mainly operate in a single state but have
customers across the U.S. Earlier this year the New York Supreme Court
backed a state law that requires Amazon.com (AMZN) and other online
retailers to charge sales tax on residents' purchases. "The big question
here is whether you have to pay taxes where you don't have a physical
presence," says Walter Hellerstein, a professor at the University of Georgia
School of Law. "That's a huge dollar issue for companies.

How huge? Massachusetts tax officials estimate they
will be able to collect an extra $20 million from companies following the
Cap One ruling and another against Toys 'R' Us. That's a significant sum in
the state, which collected $1 billion last year in corporate income taxes,
according to a recent study by Ernst & Young. "This is an issue states
should be paying attention to," says Kevin Brown, general counsel at the
Massachusetts Revenue Dept. "There's a lot of money at stake."

To add insult to injury, the Governor of Massachusetts (Deval Patrick) is
also trying to collect Mass. sales taxes of purchases made by Mass. residents
when they travel outside the State of Massachusetts. For example suppose a
resident of Boston travels to bordering New Hampshire where there is no sales
tax and buys a set of tires, Gov. Patrick wants the N.H. retailer to collect and
transmit the Mass. sales tax. It would help retailers outside of Mass. if Mass.
residents would wear a scarlet letter M
around their necks when traveling out of state. That would help retailers
distinguish Mass. shoppers from other shoppers. Otherwise there is no legal way
to identify a Massachusetts resident traveling out of state.

From The Wall Street Journal Accounting Weekly Review on June 25, 2009

SUMMARY: Given
the impact of the economic downturn on state coffers, legislatures are
considering levying state sales tax collection requirements for on-line
sales. The main article was written following the North Carolina
legislature's proposal to take this step; a subsequent article reports that
Amazon made similar warnings to California, Hawaii and other states and they
considered the same step.

CLASSROOM APPLICATION: Coverage
of state sales taxes at an introductory accounting level is the focus of the
questions.

QUESTIONS:
1. (Introductory)
How do companies which charge sales taxes remit them to government
authorities? Describe your answer in terms of general journal summary
entries for each step in the process.

2. (Advanced)
What is the difference between sellers' collection of sales taxes on sales
made in "brick and mortar" stores and those made online?

3. (Advanced)
How are sales taxes on online sales supposed to be collected by state
governments?

4. (Introductory)
Why are states proposing now to change their laws on collection of online
sales taxes? Do you think this is the first time that such proposals have
been made?

5. (Advanced)
How does Amazon's reaction in North Carolina compare to its actions in
relation to the State of New York's recently enacted internet sales tax law?

Cash-strapped states trying to force retailers to
collect taxes on online sales are spurring efforts by Internet retailer
Amazon.com Inc. to avoid being swept under the proposed laws.

North Carolina is close to passing a law that would
force online retailers to collect the state's 4.5% sales tax from marketing
affiliates, people who get a sales commission from online customer
referrals. Amazon, of Seattle, Wash., told its North Carolina marketing
affiliates on Wednesday that it would stop doing business with them by July
1 if the law takes effect. Cutting the affiliates would enable Amazon to
avoid collecting tax on sales in the state.

"We believe the way North Carolina is going about
collecting the sales tax is unconstitutional," said Amazon spokeswoman Patty
Smith. "It isn't appropriate for us to have to comply with an
unconstitutional burden."

Hawaii is weighing a similar law. California's
Legislature earlier this year tabled a bill targeting marketing affiliates,
while Connecticut has discussed but not acted on a bill. The states see
sales taxes on online purchases as offsetting declining collections
elsewhere. A study released in April by the University of Tennessee
estimated that uncollected Internet sales taxes will cost state and local
governments more than $11 billion a year by 2012.

New York passed an Internet sales tax law last
year, which Amazon challenged in court but lost. While the retailer appeals
that ruling, it is collecting taxes from New York customers. States
including Maryland, Minnesota, and Tennessee have considered then scrapped
similar proposals.

Online shoppers are already supposed to pay tax for
items they have bought online by self-reporting taxes, but most don't
bother. Forcing e-commerce companies to collect the tax upfront could take
away some of the price advantage that online shopping has over traditional
retailing.

Amazon does collect sales tax in states such as
Washington where it has offices and warehouses. In North Carolina, the issue
boils down to whether states count marketing affiliates as commissioned
sales people with a physical presence in the state, or -- as Amazon
maintains -- merely advertising outlets.

The e-commerce tax, which would be collected on
goods such as books and digital downloads such as music, could bring North
Carolina more than $13 million in revenue next year. North Carolina state
Senator David Hoyle, a Democrat, said he supports the legislation because
the state faces a $4.7 billion budget gap.

Permitting e-commerce companies to avoid charging
and collecting taxes is "anti-competitive" for the local merchants who do
add sale tax to their sales, said Sen. Hoyle, co-chairman of the state
senate's finance committee.

Amazon and other e-commerce companies have
supported an effort by about 20 states to streamline state tax laws.
Congress is considering a law, called the "Main Street Fairness Act," based
on that effort.

In North Carolina, small businesses who make money
from Amazon's affiliate program say they're caught in the middle. Amazon
declined to say how many affiliates it has in the state.

George Trantas, of Durham, N.C., earns about $1,000
a month by referring readers of his sneaker blog to Amazon for purchases. He
opposes the bill.

"If Amazon has no people in the state, they
shouldn't have to collect taxes," Mr. Trantas said. "The state of North
Carolina is short-sighted."

The young lady looked at his awards and decorations and said, 'It looks like
you have seen a lot of action.'

'Yes, ma'am, a lot of action.'

The young lady, tiring of trying to start up a conversation, said, 'You know,
you should lighten up a little. Relax and enjoy yourself.'

The Sergeant Major just stared at her in his serious manner.

Finally the young lady said, 'You know, I hope you don't take this the wrong
way, but when was the last time you had sex?'

'1955, ma'am.'

'Well, there you are. No wonder you're so serious. You really need to chill
out! I mean, no sex since 1955! She took his hand and led him to a private room
where she proceeded to 'relax' him several times. Afterwards, panting for
breath, she leaned against his bare chest and said, 'Wow, you sure didn't forget
much since 1955.'

The Sergeant Major said in his serious voice, after glancing at his watch, 'I
hope not; it's only 2130 now.'

23-year-old Strahinja Raseta was wanted by Croatian police for murder, as
well as for a spectacular robbery of a central post office. He fled to Serbia to
evade the law.

But even bad guys have friends. Raseta had a friend, and his friend had lent
him E15,000. Some loans can never be repaid. This was such a loan. Finding
himself unable to earn or steal the funds needed to reimburse his friend, Raseta
attempted to end the matter in another way--by murdering the lender!

He crawled under his creditor's Jeep and planted an explosive. However, the
muffler was still hot, and the heat set off the explosive while Raseta was
beneath the vehicle. He died in hospital the next day in the Serbian capital
city of Belgrade, illustrating the truth of the Shakespearean adage, "Neither a
borrower nor a lender be."

Sleeping residents of Chilliwack (Canada) were awakened early one morning by
the sound of a small aircraft flying lower than usual. The engine noise was like
a mosquito, zooming too close too quick, then veering away. What the bleep was
going on? In the wee hours of the night, during a bout of heavy drinking, two
future Darwin Award nominees concluded that, with neither had a pilot's license
nor flight training, they nevertheless knew enough to pilot an aircraft. knew
all they needed to know to at a local dive, They drew the obvious conclusion,
and decided to take a plane from the small local airport for a drunken joyride
over the city. They invited two females along for the ride; fortunately, the
level-headed ladies declined.

From idea to execution, the plan evolved quickly. One of the gentlemen worked
at the airport and had access to the tarmac. The two men then managed to unlock
a plane and get it off the ground and into the sky. They went on to buzz around
in the dark, skimming above the roofs of the houses. This went on for an
extended period of time.

Eventually they decided to land. They attempted to land on the grassy median
between east and west-bound lanes of the Trans Canada Highway. They almost made
it under the electrical wires that cross the median. Almost. Where these wires
were concerned, fate intervened. Instead of making a soft landing on the grassy
verge, the tail clipped the wires, sending the aircraft diving nose-first into
the ground and killing both occupants.

Only then were the sleepy Chilliwack residents able to return to their REM
sleep.

Forwarded by Maxine

Yesterday I confused by Poli-Grip with my Preparation H.
Now I talk like an a-hole but my gums don't itch.

Forwarded by Gene and Joan

Did you hear about the 83 year old woman who talked herself out of a speeding
ticket by telling the young officer that she had to get there before she forgot
where she was going?

Makes perfectly good sense to me.....

Forwarded by Gene and Joan

In the British game of cricket, the first testicular guard was used in
1874.

The first helmet was used in 1974.

It took 100 years for men to realize that their brain could also be
important.

Forwarded by Maureen

A Woman's Perfect Breakfast

She's sitting at the table with her gourmet coffee.
Her son is on the cover of the Wheaties box.
Her daughter is on the cover of Business Week.
Her boyfriend is on the cover of Playgirl.
And her husband is on the back of the milk carton

Forwarded by Barb Hessel

An Old Farmer's Advice

Your fences need to be horse-high, pig-tight, and bull-strong.

Keep skunks and bankers at a distance.

Life is simpler when you plow around the stump.

A bumblebee is considerably faster than a John Deere tractor.

Words that soak into your ears are whispered . . . not yelled.

Meanness don't jes' happen overnight.

Forgive your enemies. It messes up their heads.

Do not corner something that you know is meaner than you.

It don't take a very big person to carry a grudge.

You cannot unsay a cruel word.

Every path has a few puddles.

When you wallow with pigs, expect to get dirty.

The best sermons are lived, not preached.

Most of the stuff people worry about ain't never gonna happen anyway.

Don't judge folks by their relatives.

Remember that silence is sometimes the best answer.

Live a good, honorable life. Then, when you get older and think back, you'll
enjoy it a second time.

Don't interfere with somethin' that ain't botherin' you none.

Timing has a lot to do with the success of the rain dance.

If you find yourself in a hole, the first thing to do is stop digging.

The biggest troublemaker you'll probably ever have to deal with, watches you
from the mirror every morning.

Always drink upstream from the herd.

Good judgment comes from experience . . . and a lot of that comes from bad
judgment.

Lettin' the cat outta th' bag is a whole lot easier than puttin' him back in.

If you get to thinkin' you're a person of some influence, jes' try orderin'
somebody else's dog around.

Don't pick a fight with an old man. If he's too old to fight, he'll jes' kill
ya.

Sometimes you get; and, sometimes you get got.

Forwarded by Maureen

BBQ RULES
We are about to enter the BBQ season. Therefore it is important to refresh your
memory on the etiquette of this sublime outdoorcooking
activity.When
a man volunteers to do the BBQ the following chain of events are put into
motion:

1. You had to wash the clothes line before hanging any clothes - walk the
entire lengths of each line with a damp cloth around the lines. 2. You had to
hang the clothes in a certain order, and always hang "whites" with "whites," and
hang them first. 3. You never hung a shirt by the shoulders - always by the
tail!. What would the neighbors think? 4. Wash day on a Monday! ... Never hang
clothes on the weekend, or Sunday, for Heaven's sake! 5. Hang the sheets and
towels on the outside lines so you could hide your "unmentionables" in the
middle (perverts & busybodies, y'know!). 6. It didn't matter if it was sub zero
weather ... Clothes would "freeze-dry." 7. Always gather the clothes pins when
taking down dry clothes! Pins left on the lines were "tacky!" 8. If you were
efficient, you would line the clothes up so that each item did not need two
clothes pins, but shared one of the clothes pins with the next washed item. 9.
Clothes off of the line before dinner time, neatly folded in the clothes basket,
and ready to be ironed. 10. IRONED?! Well, that's a whole other subject!

A Poem

A clothesline was a news forecast To neighbors passing by, There were no
secrets you could keep When clothes were hung to dry.

It also was a friendly link For neighbors always knew If company had stopped
on by To spend a night or two.

For then you'd see the "fancy sheets" And towels upon the line; You'd see the
"company table cloths" With intricate designs.

The line announced a baby's birth From folks who lived inside - As brand new
infant clothes were hung, So carefully with pride!

The ages of the children could So readily be known By watching how the sizes
changed, You'd know how much they'd grown!

It also told when illness struck, As extra sheets were hung; Then
nightclothes, and a bathrobe, too, Haphazardly were strung.

It also said, "Gone on vacation now" When lines hung limp and bare. It told,
"We're back!" when full lines sagged With not an inch to spare!

New folks in town were scorned upon If wash was dingy and gray, As neighbors
carefully raised their brows, And looked the other way . .

But clotheslines now are of the past, For dryers make work much less. Now
what goes on inside a home Is anybody's guess!

I really miss that way of life. It was a friendly sign When neighbors knew
each other best By what hung on the line.

Forwarded by Paula

These were posted on an
Australian Tourism Website and the answers are the actual responses by the
website officials, who obviously have a great sense of humour.
__________________________________________________
Q: Does it ever get windy in Australia ? I have
never seen it rain on TV, how do the plants grow? (UK ).
A: We import all plants fully grown and then just sit around watching them die.
__________________________________________________
Q: Will I be able to see kangaroos in the street? ( USA )
A: Depends how much you've been drinking.
__________________________________________________
Q: I want to walk from Perth to Sydney - can I follow the railroad tracks? (Sweden)
A: Sure, it's only three thousand miles, take lots of water.
__________________________________________________
Q: Are there any ATMs (cash machines) in Australia ? Can you send me a list of
them in Brisbane, Cairns,
Townsville and HerveyBay? ( UK )
A: What did your last slave die of?
__________________________________________________
Q: Can you give me some information about hippo racing in Australia ? ( USA)
A: A-fri-ca is the big triangle shaped continent south of
Europe. Aus-tra-lia
is that big island in the middle of the Pacific which does not.... oh forget it.
Sure, the hippo racing is every Tuesday night in Kings Cross. Come naked.
__________________________________________________
Q: Which direction is North in Australia? ( USA )
A: Face south and then turn 180 degrees. Contact us when you get here and we'll
send the rest of the directions.
_________________________________________________
Q: Can I bring cutlery into Australia ? ( UK )
A: Why? Just use your fingers like we do.
__________________________________________________
Q: Can you send me the Vienna Boys' Choir schedule? ( USA )
A: Aus-tri-a is that quaint little country bordering Ger-man-y, which is…oh
forget it. Sure, the Vienna Boys Choir
plays every Tuesday night in Kings Cross, straight after the hippo races. Come
naked.
__________________________________________________
Q: Can I wear high heels in Australia? ( UK )
A: You are a British politician, right?
____________________________ ______________________
Q: Are there supermarkets in Sydney and is milk available all year round?
(Germany)
A: No, we are a peaceful civilization of vegan hunter/gatherers. Milk is
illegal.
__________________________________________________
Q: Please send a list of all doctors in Australia who can Dispense
rattlesnake serum. (USA)
A: Rattlesnakes live in A-meri-ca which is where YOU come from. All Australian
snakes are perfectly harmless, can be safely handled and make good pets.
__________________________________________________
Q: I have a question about a famous animal in Australia, but I forget its name.
It's a kind of bear and lives in trees. (USA )
A: It's called a Drop Bear. They are so called because they drop out of Gum
trees and eat the brains of anyone walking underneath them. You can scare them
off by spraying yourself with human urine before you go out walking.
__________________________________________________
Q: I have developed a new product that is the fountain of youth. Can you tell
me where I can sell it in Australia? (USA )
A: Anywhere significant numbers of Americans gather.
__________________________________________________
Q: Can you tell me the regions in Tasmania where the
female population is smaller than the male population? (Italy )
A: Yes, gay night clubs.
__________________________________________________
Q: Do you celebrate
Christmas in Australia? (France )
A: Only at Christmas.
__________________________________________________
Q: I was in Australia in 1969 on R+R, and I want to contact the Girl I dated
while I was staying in Kings Cross. Can
you help? (USA )
A: Yes, and you will still have to pay her by the hour.
__________________________________________________
Q: Will I be able to speak English most places I go? ( USA )
A: Yes, but you'll have to learn it first.

Daily Humor (mostly humor but not always)
Snopes also has an interesting page called Odd News that I intend to examine
daily since the items on this page are transient ---
http://www.snopes.com/daily/

Forwarded by Paula

His request approved, the CBC (Canada) news photographer quickly used a cell
phone to call the local airport to charter a flight. He was told a twin engine
plane would be waiting for him at the airport.

Arriving at the airfield, he spotted a plane warming up outside a hanger. He
jumped in with his bag, slammed the door shut, and shouted, "Let's go."

The pilot taxied out, swung the plane into the wind and took off. Once in the
air, the photographer instructed the pilot: "Fly over the valley and make low
passes so I can take pictures of the fires on the hillsides."

"Why?" asked the pilot.

"Because I'm a photographer for CBC News," he

Responded. "And I need to get some close up shots."

The pilot was strangely silent for a moment. Finally he stammered: "So, what
you're telling me is .... you're NOT my flight instructor."

Forwarded by Paula

A very gentle Seguin, Texas lady was driving across a high bridge in Texas
one day. As she neared the top of the bridge, she noticed a young man getting
ready to jump. She stopped her car, rolled down the window and said, "Please
don't jump, think of your dear mother and father."

Robert Whiting, an elderly gentleman of 83, arrived in
Paris by plane. At French Customs, he took a few minutes to locate his passport
in his carry on.

'You have been to France before, monsieur?' the customs
officer asked sarcastically.

Mr. Whiting admitted that he had been to France previously.
'Then you should know enough to have your passport ready.'

The American said, 'The last time I was here, I didn't have
to show it.

'Impossible. Americans always have to show your passports
on arrival in France !'

The American senior gave the Frenchman a long hard look.
Then he quietly explained, 'Well, when I came ashore at Omaha Beach on D-Day in
1944 to help liberate this country, I couldn't find a single Frenchmen to show a
passport to.'

Guess
I am older than dirt, I remembered all of them.'Someone asked the other day, 'What was your favorite fast-food
when you were growing up?'

'We didn't
have fast food when I was growing up,' I informed him.

'All the
food was slow.'

'C'mon, seriously. Where did you eat?'

'It was a
place called 'at home,'' I explained.

'Mom cooked
every day and when Dad got home from work, we sat down together at the dining
room table, and if I didn't like what she put on my plate I was allowed to sit
there until I did like it.'

By this time, the kid was laughing so hard I was afraid he was going to suffer
serious internal damage, so I didn't tell him the part about how I had to have
permission to leave the table.

But here
are some other things I would have told him about my childhood if I figured his
system could have handled it:

Some
parents NEVER owned their own house, wore Levis , set foot on a golf course,
traveled out of the country or had a credit card.

In their
later years they had something called a revolving charge card. The card was good
only at Sears Roebuck. Or maybe it wasSears & Roebuck

Either way,
there is no Roebuck anymore. Maybe he died.

My parents never drove me to soccer practice. This was mostly because we never
had heard of soccer. I had a bicycle that weighed probably 50 pounds, and only
had one speed, (slow).

We didn't
have a television in our house until I was 5.

It was, of
course, black and white, and the station went off the air at midnight, after
playing the national anthem and a poem about God; it came back on the air at
about 6 a.m. and there was usually a locally produced news and farm show on,
featuring local people.

I was 13 before I tasted my first pizza, it was called 'pizza pie.'

When I bit
into it, I burned the roof of my mouth and the cheese slid off, swung down,
plastered itself against my chin and burned that, too. It's still the best pizza
I ever had.

We didn't have a car until I was 4. It was an old black Dodge.

I never had a telephone in my room.

The only
phone in the house was in the living room and it was on a party line. Before you
could dial, you had to listen and make sure some people you didn't know weren't
already using the line.

Pizzas were
not delivered to our home. But milk was.

All
newspapers were delivered by boys and all boys delivered newspapers --my brother
delivered a newspaper, six days a week. It cost 7 cents a paper, of which he got
to keep 2 cents. He had to get up at 6AM every morning.

On
Saturday, he had to collect the 42 cents from his customers. His favorite
customers were the ones who gave him 50 cents and told him to keep the change.
His least favorite customers were the ones who seemed to never be home on
collection day.

Movie stars
kissed with their mouths shut. At least, they did in the movies. There were no
movie ratings because all movies were responsibly produced for everyone to enjoy
viewing, without profanity or violence or most anything offensive.

If you grew up in a generation before there was fast food, you may want to share
some of these memories with your children or grandchildren. Just don't blame me
if they bust a gut laughing.

Growing up
isn't what it used to be, is it?

MEMORIES
from a friend :

My Dad is
cleaning out my grandmother's house (she died in December) and he brought me an
old Royal Crown Cola bottle. In the bottle top was a stopper with a bunch of
holes in it. I knew immediately what it was, but my daughter had no idea. She
thought they had tried to make it a salt shaker or something. I knew it as the
bottle that sat on the end of the ironing board to 'sprinkle' clothes with
because we didn't have steam irons. Man, I am old.

How many do
you remember?

Head lights dimmer switches on the floor.
Ignition switches on the dashboard.
Heaters mounted on the inside of the fire wall.
Real ice boxes.
Pant leg clips for bicycles without chain guards.
Soldering irons you heat on a gas burner.
Using hand signals for cars without turn signals.

Although I don't use Twitter, members of the American
Accounting Association may now view the AAA's tweets at
http://twitter.com/aaahq

Congratulations Ira

AAA V-P and head of Illinois
Urbana-Champaign, Ira Solomon, has received the AICPA’s Distinguished
Achievement in Accounting Education award (http://preview.tinyurl.com/d3f7sd).
Many on this list will know of Ira’s innovative and
important work with Project Discovery at UIUC (also thoroughly adopted at
Nanyang Technological University in Singapore), his monographs with Tim Bell
and Mark Peecher and the KPMG Audit Cases.

What happens to U.S. GAAP literature when the Codification goes live on July 1,
2009?All
existing standards that were used to create the Codification will become
superseded upon the adoption of the Codification. The FASB will no longer
update and maintain the superseded standards. Also, upon adoption of the
Codification, the U.S. GAAP hierarchy will flatten from five levels to
two­authoritative and non-authoritative. The following table illustrates the
result:DON’T BE CAUGHT-OFF GUARD! GET READY FOR THE CODIFICATION!

The FASB is expected to institute a major change in the way accounting standards
are organized. The FASB Accounting Standards CodificationTM is
expected to become the single official source of authoritative, nongovernmental
U.S. generally accepted accounting principles (GAAP).After final
approval by the FASB only one level of authoritative GAAP will exist, other than
guidance issued by the Securities and Exchange Commission (SEC). All other
literature will be non-authoritative.While the FASB Codification is designed to make it much easier to research
accounting issues, the transition to use of the Codification will require some
advance training. These weekly “Countdown to Codification” alerts are designed
to provide tips to make that transition easier.The FASB offers a free online tutorial at
http://asc.fasb.org. A recorded instructional webcast­The Move to
Codification of US GAAP, first presented live on March 13, 2008­also is
available at
http://www.fasb.org/fasb_webcast_series/index.shtml. In addition,
Codification training opportunities are offered through professional accounting
organizations such as the American Institute of Certified Public Accountants (AICPA).

Does anybody know how the codification will affect
services like PwC Comperio, or any other of the third party accounting
research products that are out there?

Thanks,
Tom Selling

May 12, 2009 reply from Bob Jensen

Hi Tom,

I can’t imagine that the FASB Codification is any threat to the much more
comprehensive database services such as PwC’s Comperio. Nor is it any threat
to Web crawlers like Google. Firstly, Comperio covers auditing standards as
well as accounting standards. Comperio also covers other topics such as some
AIS topics. Secondly, Comperio covers international standards and many
foreign domestic standards. Thirdly, Comperio covers millions of
communications not available in the Codification database. Google has
warehoused billions upon billions of more communications on accounting,
auditing, and related topics.

The FASB Codification compliments Comperio and will make Comperio itself
more efficient. What the Codification attempts to do is to consolidate
disparate documentation (standards, interpretations, memoranda, FSPs, EITFs,
etc.) together on each major topic. Comperio will eventually build on the
Codification consolidations. More importantly, it seems that the
Codification adds important illustrations of implementation. Sadly, it also
omits many important illustrations such as some of the longer and extremely
important illustrations from the appendices of FAS 133. The EITFs have many
illustrations and debates not yet available in the Codification database.
Hence, I do not think it’s time to chuck the hard copy even if you have both
the Codification and the Comperio databases at your disposal.

There are still many other gaps in the Codification database such as the
huge collection of DIGs for FAS 133. This is just another illustration that
the Codification database is a work in progress with very limited resources
comparison to Comperio and most certainly Google.

Personally, I’ve been disappointed in the Codification database to date.
And I’ve found the search engine of Comperio and the IASB search engine
(which I really like) for its international standards database to be much
more comprehensive and efficient than the Codification search engine. The
Codification Glossaries need a lot of work. Personally I prefer my own
glossary of FAS 133 and IAS 30 ---
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

One way, albeit an expensive way, to make the Codification database more
effective and comprehensive would be to make it more Web friendly. For
example FASB standards are covered in many “blogs” such as AccountingWeb,
SmartPros, IAS Plus, Jensen’s Threads, the AECM, etc. Adding links to
important modules in those blogs for references would greatly expand upon
major topics that are sometimes barely outlined in the Codification
database.

Another way is to either serve up video in the Codification database or
link to video on important topics. These include suggested search terms that
make it easier to find videos on YouTube, college course tutorials,
professional organization videos (such as those from the AICPA), etc.

The FASB did a lot with the limited resources at hand when it built the
Codification database to date. But it has a long, long, long way to go as
far as I’m concerned. Students and practitioners who confine their research
to the Codification database will be missing an enormous amount of the
bigger picture. Don’t cancel your library subscription to Comperio for a
long, long time into the future.

FASB took
another step forward in its plan to codify U.S. GAAP with the release Friday
of an exposure draft on changes to the GAAP hierarchy.

FASB is
taking comments on theproposaluntil May 8.
In the draft, the standard setter reiterates the planned July 1 effective
date for the FASB AccountingStandards Codification to become
the single source of authoritative U.S. accounting and reporting standards,
except for SEC rules and interpretive releases.

The 20-page
proposal would modify FASB Statement no. 162, The Hierarchy of GenerallyAccepted Accounting Principles. The proposal would establish only two
levels of GAAP—authoritative and nonauthoritative.

As of July 1, the FASB
AccountingStandards Codification (ASC) would supersede all
then-existing, non-SEC accounting and reporting standards for
nongovernmental entities. The FASB ASC disassembled and reassembled
thousands of nongovernmental accounting pronouncements (including those of
FASB, the Emerging Issues Task Force, and the AICPA) to organize them under
roughly 90 topics and include all accounting standards issued by a standard
setter within levels A–D of the current U.S. GAAP hierarchy. The ASC also
includes relevant portions of authoritative content issued by the SEC, as
well as selected SEC staff interpretations and administrative guidance
issued by the SEC.

FASB points
out in the exposure draft that it decided to include in the codification the
AICPA Technical Inquiry Service (TIS) Section 5100, Revenue Recognition,
paragraphs 38–76, which may result in an accounting change for private
entities that had not previously applied the guidance. FASB provided
specific transition provisions for private entities affected by the change.

The board that sets U.S. accounting standards on
Monday moved to end companies' use of a device that allowed them to park
hundreds of billions of dollars in loans off their balance sheets without
capital cushions and has been blamed for helping stoke banks' losses in the
housing boom.

The change will tighten the use of so-called
"qualifying special purpose entities" by requiring companies to report to
regulators the loans contained in them and to increase their capital
reserves in proportion as a cushion against potential losses.

It was the lack of disclosure and absence of
capital supporting ballooning subprime mortgage loans in these special
entities that aggravated the massive losses sustained by banks, regulators
say.

The change by the Financial Accounting Standards
Board could result in about $900 billion in assets being brought onto the
balance sheets of the nation's 19 largest banks, according to federal
regulators. The information was provided by Citigroup Inc., JPMorgan Chase &
Co. and 17 other institutions during the government's recent "stress tests,"
an analysis designed to determine which banks would need more capital if the
economy worsened.

In its quarterly regulatory filing earlier this
month, Citigroup said the rule change could have "a significant impact" on
its financial statements. Citigroup estimated it would result in the
recognition of $165.8 billion in additional assets, including $90.5 billion
in credit card loans.

JPMorgan estimated in its quarterly filing that the
impact of consolidation of the bank's qualifying special purpose entities
and variable interest entities could be up to $145 billion.

In general, companies transfer assets from balance
sheets to special purpose entities to insulate themselves from risk or to
finance a large project. Under the change by the FASB, many qualifying
special purpose entities will have to be moved back to a company's main
balance sheet.

Outside investors often take interests in those
entities, for example, making an investment in a bank's holdings of mortgage
loans in exchange for payments from borrowers. Under the new standard,
companies must bring back any entity in which they hold an interest that
gives them "control over the most significant activities," according to
FASB. Companies must perform analyses to determine that.

In cases where companies have "continuing
involvements" with off-balance-sheet entities, they will have to provide new
disclosures.

"That's a step in the right direction," said Edward
Ketz, an associate professor of accounting at Pennsylvania State University.
He cited estimates that U.S. banks will need to report up to $1 trillion in
loans due to the rule change.

The FASB said the rule change was intended "to
improve consistency and transparency in financial reporting." The FASB voted
5-0 to adopt it at a public meeting of its board at its headquarters in
Norwalk, Conn. A revised proposal had been opened to a public comment period
that ended in November.

The rule change, which applies both to public and
privately held companies, takes effect for companies' annual reporting
periods starting after Nov. 15.

"It's great to see that they didn't defer it," said
Jack Ciesielski, a Baltimore-based accounting expert who writes a financial
newsletter. Investors finally "will get an idea of how leveraged these
things really are," he said.

The change by FASB cuts in the opposite direction
of its move last month - surrounded by controversy and with some dissension
by board members - giving companies more leeway in valuing assets and
reporting losses. That revision in the so-called "mark-to-market" accounting
rules was expected to help boost battered banks' balance sheets, while the
new rule change likely will result in financial institutions recognizing on
their books billions in high-risk loans that may default.

FASB acted on the mark-to-market rules amid intense
pressure from Congress, which threatened legislation. The board received
hundreds of comment letters opposing the move from mutual funds, accounting
firms and others contending that it would damage honest financial reckoning
by masking the deficiencies and risks lurking within the system.

Thomson Reuters tax expert obtains guidance from
the IRS on the issue of separate vehicle purchases and the new sales tax
deduction.

In an effort to stimulate automobile sales, the
American Recovery and Reinvestment Act of 2009 included a new income tax
deduction for state or local sales or excise taxes paid on qualifying motor
vehicle purchases made after February 16, 2009 and before January 1, 2010.
The deduction is limited to the taxes on the first $49,500 of the cost of
the vehicle. A previous release from the Tax & Accounting business of
Thomson Reuters (dated March 2nd) stated that the legislation was unclear as
to whether this limitation applied to an individual’s total vehicle
purchases or each separate vehicle purchase, and that presumably the IRS
would address this in guidance.

The IRS has not yet issued formal guidance on this.
However, William E. Massey, a Senior Tax Analyst from the Tax & Accounting
business of Thomson Reuters, contacted the IRS about this issue and a
spokesperson from its National Media Relations office responded as follows:
“If you buy a car costing more than $49,500, you get a deduction based only
on the first $49,500 of the purchase price. The limitation is imposed on a
per vehicle basis. Accordingly, a taxpayer may deduct the taxes paid on the
purchase of more than one vehicle, even if the total of the purchase price
exceeds $49,500. There is no limitation on the number of vehicles an
individual can purchase.”

“This is good news for a taxpayer who needs to
purchase two or more cars this year. Under the position stated by the IRS
spokesperson, he or she can deduct the sales taxes on the first $49,500 of
the purchase price of each one,” notes Massey. For example, an individual
could buy a car for use in his or her business and another for personal use
and deduct the taxes up to the limit on each vehicle.

“Keep in mind, the deduction isn’t limited to
cars,” reminds Massey. “Qualifying vehicles also include light trucks and
motorcycles, as well motor homes.” In all cases, the original use of the
vehicle must commence with the taxpayer. Massey observes that “this means
that the motor vehicle must be brand new to qualify. But this does not mean
that only 2009 or 2010 model year vehicles may qualify. A 2008 or earlier
model may qualify as long as it is brand new when purchased by the taxpayer
this year after February 16.”

While there is no limit on the number of vehicles
that can qualify for the new deduction, there is an income limit. Under this
limit, the amount of sales or excise taxes that may be treated as qualified
motor vehicle taxes is phased out ratably for a taxpayer with modified AGI
(MAGI) between $125,000 and $135,000 ($250,000 and $260,000 on a joint
return). MAGI is adjusted gross income computed in a special way.

Jensen Comment
Darn! I'm screwed out of this tax break since New Hampshire has no sales tax.
But I'm still waiting to get $4,500 on my 1989 Cadillac that I inherited from my
father in 2001. My dilemma is that nothing has ever gone wrong with this car and
it appears to be better than any car manufactured these days.

I've been assigned to teach a course in "Strategic
Management Accounting" as part of our summer session offerings for final
year BBA undergraduate accounting majors. The previous presenter of the
course built it around a set of cases plus a simulation - VK Gadget. See..
http://www.microbuspub.com/maspg3.htm

While I'm in general agreement with the approach
I'm wondering whether anyone on the list has experience of the VK Gadget
simulation, or of any other simulations that they would think appropriate.
There is an optional text with the simulation - "Management Accounting - A
Venture Into Decision Making" - but our students have a more in-depth
knowledge of management accounting by the time they reach their final year
than this book provides.

The only potential alternative that I've discovered
to the VK Gadget simulation so far is "The Business Strategy Game" from
Globus.See..http://www.glo-bus.com

I get the impression that this simulation is easier
to run and to administer than VK Gadget (important to me, as I have to get
up to speed quickly) but it doesn't seem to go into management accounting
issues in such depth.

I used the Management Accounting Simulation from
the same company. I found it required a significant investment on the part
of students before they ever could get started. The time and effort needed
was so significant, that only two groups of two students even went ahead
with the investment. Most students just entered numbers. I was using the
simulation for cost accounting students, which I find to be more dedicated
to work than the typical managerial accounting students.

What was scariest was the amount of work that would
be required of the professor before even starting. I had difficulty in
figuring out what to do from the instructions. I think I could have figured
it out eventually if I had gone ahead and made the time investment and
completed the assignments, just like I later asked the students to do. My
estimate was about 25 hours to get up to speed, and I wasn't willing to make
that investment. No wonder most students didn't do it either.

I found the instructions to administer the game to
be confusing, and I couldn't even input data without being talked through it
by the simulation author.

My campus bookstore charged students 38.40 for the
instruction book. I eventually dropped the simulation, and refunded students
their 38.40 from my own pocket (ouch).

I don't know if the simulation game you are talking
about is the same, or a related product by the same company, but I'd be very
skeptical.

A far better managerial accounting simulation is to
use a business computer game called Gazillionaire (from Lavamind). In this
computer game, each player owns a company with two products/services--either
transporting passengers or transporting materials/products on the single
company vessel. Each player must make decisions about financing, setting
prices, allocating space on vessel between passengers/cargo, purchase of
insurance, payment of taxes, where to travel, etc.

I have students play the game until they figure out
the various components. Then I have the students play the game on paper
until they have a plan that will work: enable them to ultimately accumulate
retained earnings of 1,000,000. Once I approve their plans, they go ahead
and play the game and then do a variance analysis, and figure out what they
can do for the next time they play they play the simulation game.

If anyone goes this route, I can share my very
rudimentary instructions. Also, I warn: students must truly immerse
themselves in the business--figuring out what info they need that can help
them cut costs and increase revenues. It cuts down on the amount of
classroom content that can be covered. But it is well worth it.

Sometimes I hear from students that they learned
more from my monopoly simulation game and gazillionaire simulation game than
the rest of their collegiate experience.

Most of the administration can be undertaken by the
helpful staff at Smartsims. The multiplayer version is housed on their
servers and can be accessed by anyone (who has paid the requisite fee) with
an internet connection.

I have run in it our Strategic Management
Accounting course for five years. Students find it easy to access and use. I
form them into teams and they compete against each other to manufacture and
sell bicycles (no knowledge of bicycle manufacture required).

Assessment is around a business plan and
establishing KPI (along the lines of a 'balanced score card'). Each team is
'in business' for a number of years and they are to report on successes and
failures. It doesn't necessarily focus on the technical skills of
'management accounting' - we cover and assess through other mechanisms - but
does really open their minds to the strategic, and integrated, nature of
decision making. It requires that they develop the soft skills that
accounting bodies expect to be squeezed into the curriculum. Students do
enjoy the competitive nature of the challenge.

The Mike's Bikes author is Pete Mazany. Pete's one of Frank's colleagues
on the faculty at the University of Auckland. In the past, In the past I've
used Pete in my technology workshops. If management accounting is to be
emphasized to students who are relatively advanced in management accounting,
the Mike's Bikes case may be too superficial in terms of accounting content,
although this is an excellent policy decision making simulation. The case is
networked and online. Pete spent a lot of money and time in programming this
simulation. Pete earned his doctorate at Yale under one of the top game
theory scholars of the world.

There is an excellent case study directory at Michigan State University
---
http://aib.msu.edu/resources/casedepositories.asp
Most cases are not simulations. However, enter "simulation" in the search
box on the left margin of the AIB home page and see what you find.

It is not common to find simulation cases with good accompanying
textbooks. One problem is that if the simulation cases are updated quite
often, the accompanying textbook may be a little out or date. If neither the
simulation case nor the textbook is updated quite often, then I become
dubious about using such material over time. Updating financial accounting
simulations is probably a bigger problem relative to managerial accounting
because of the way financial accounting standards are amended monthly.

Das VoondeBar: New German Accounting Law
Includes capitalization of internally-generated intangibles and consolidation of
SPEs

The German
Parliament has passed the Act to Modernise
Accounting Law (in German:
Bilanzrechtsmodernisierungsgesetz). A goal of
the legislation is to reduce the financial reporting
burden on German companies. The accounting
requirements under the Act are described as an
alternative to International Financial Reporting
Standards for small and medium-sized companies that
do not participate in capital markets. In announcing
the new law, the German Federal Ministry of Justice
(which administers the Commercial Code (ComC) in
Germany) said:

The
modernised ComC accounting law is also an
answer to the International Financial
Reporting Standards (IFRS), published by the
International Accounting Standards Board (IASB).
The IFRS are geared to suit capital market
oriented enterprises; in other words, they
also serve information needs of financial
analysts, professional investors and other
participants in the capital markets.

By far the majority of those German
enterprises that are required by law to keep
accounts and records do not take part in the
capital market at all. For this reason,
there is no justification for committing all
the enterprises that are required to keep
accounts and records to the cost-intensive
and highly complex IFRS. Also the draft
recently discussed by the IASB of a standard
IFRS for Small and Medium-Sized Entities
is not a good alternative for drawing up an
informative annual financial statement.
Practitioners in Germany have strongly
criticised the IASB draft because its
application – compared with ComC accounting
law – would still be much too complicated
and costly.

The law exempts 'sole
merchants' (prorietorships) with less than €500,000
turnover and Euro 50,000 profit from any obligation
to keep accounts and records. Small companies (less
than 50 employees, assets of €4.8 million, and
annual turnover of €4.8 million) need not have an
audit and may publish only a balance sheet.
Medium-sized companies (less than 250 employees,
assets of €19.2 million, and annual turnover of
€38.5 million) have reduced disclosure requirements
and may combine balance sheet items. Among the new
accounting provisions of the ComC:

Companies
will be permitted to capitalise internally
generated intangible assets, while getting an
immediate tax deduction for the costs.

Financial
institutions will measure financial instruments
designated as 'held for trading' at fair value,
with value changes recognised in a 'special
reserve'. The Ministry of Justice press release
states: 'This special reserve has to be built up
from part of the enterprise's trading profits
when times are good and can then be used to
offset trading losses when times get worse.
Hence this special provision has an anticyclical
effect. Here the necessary steps have been taken
in order to respond to the financial markets
crisis.'

Special
purpose entities that are controlled must be
consolidated.

The new law takes
effect 1 January 2010, with early application for
2009 permitted. Click for

Jensen Comment
This illustrates how European nations may pass accounting laws in spite of being
subject to IFRS in the EU.

As the FASB goes, so goes ?????The EU's finance ministers and the European Commission
are ratcheting up pressure on the setters of accounting standards in Europe to
soften their rules on valuing assets. Finance ministers threatened to summon a
representative of the International Accounting Standards Board (IASB) to their
next meeting in June to explain its stance. Christine Lagarde, France's finance
minister, said this week that the IASB's response so far had not been
sufficient.
"European Ministers Put Pressure on Accounting Standards Board," CFO.com,
May 7, 2009 ---
http://www.cfo.com/article.cfm/13613096/c_2984368/?f=archives

A class-action lawsuit, settled earlier this week, says the
audit firm should have considered the homebuilder's "make the numbers" culture
to be a red flag as the housing market tanked.

Deloitte & Touche has agreed to pay investors of
Beazer Homes USA nearly $1 million to settle claims the firm should have
noticed the homebuilder was issuing inaccurate financial statements as the
housing market began to decline earlier this decade.

The audit firm, Beazer, and former Beazer
executives have settled the class-action lawsuit for a total of $30.5
million, pending approval by the U.S. District Court for the Northern
District of Georgia. Deloitte is scheduled to pay $950,000.

The investors had accused Beazer of managing
earnings, recognizing revenue earlier than allowed under generally accepted
accounting principles, improperly accounting for sales/leaseback
transactions, creating "cookie jar" reserves, and not recording land and
goodwill impairment charges at the proper time.

For example, according to the allegations, Beazer
conducted house closings on homes that weren't move-in ready to push up the
date the company could record the revenue from the sales and backdated
documents of home sales so that they could be recorded in earlier financial
reporting periods. Under FAS 66, Accounting for Sales of Real Estate, the
seller recognizes its profit only after a sale is completed.

In a complaint filed nearly two years ago, the
plaintiffs said that because of Beazer's culture to "make the numbers"
during a time when housing sales had significantly slowed, the company's
employees were dealing with unrealistic budgets and pressure to hit
financial goals or risk losing their jobs — and that Deloitte should have
noticed these issues existed and planned its audit accordingly.

The investors accused Deloitte of turning "a blind
eye" to the myriad of "red flags" that should have alerted the firm to
potential GAAP violations. These warning signs included the "excessive
pressure" employees were under to meet their higher-ups' sales goals, tight
competition in Beazer's market, and weak internal controls. Accusing the
auditor of "severe recklessness," the shareholders alleged, for example,
that Deloitte should have noticed that Beazer was likely overdue in
recording impairments on their land assets, as the real estate market began
to decline, among other the other alleged accounting violations.

"Deloitte either knowingly ignored or recklessly
disregarded Beazer's wide-ranging material control deficiencies and material
weaknesses during the class period," according to the shareholders'
complaint. "For example, Deloitte was specifically aware that financial
periods were regularly held open or re-opened because it had access to
Beazer's detailed financial and accounting information via, among other
means, access to Beazer's JD Edwards software."

In an educational brochure on public-company
accounting released yesterday, the Center for Audit Quality, the trade group
for audit firms, said auditors consider potential areas of misconduct for a
particular company when deciding what areas of a business to review.
However, the CAQ cautioned, "because auditors do not examine every
transaction and event, there is no guarantee that all ma­terial
misstatements, whether caused by error or fraud, will be detected."

In the Beazer settlement, none of the defendants
has admitted wrongdoing. "Deloitte denies all liability and settled to avoid
the expense and uncertainty of continued litigation," a spokeswoman told
CFO.com.

For its part, Beazer says its insurance provider
will pay for the settlement, meaning "there will be no financial
contribution by the company." By settling, the firm added, "the
uncertainties, distractions, burden and further expense associated with this
litigation" have been eliminated.

The suit's plaintiffs include institutional
investor Glickenhaus & Co., Northern California Carpenters Pension Fund, and
other pension funds. Shareholders holding Beazer stock between January 2005
and May 2008 would benefit from the settlement.

Last year, Beazer restated several years' worth of
financial statements to fix many of the same issues mentioned in the
class-action suit. An internal investigation into its mortgage-origination
business also resulted in the firing of its chief accounting officer who was
accused of violating the company's ethics policy by trying to destroy
company documents.

Beazer settled a related case with the U.S.
Securities and Exchange Commission without paying any penalty. It is still
under investigation by the U.S. Attorney's Office in North Carolina,
according to its most recent 10-K.

With expenses such as business lunches being
curtailed and a dwindling list of new clients, Wayne Nelms knew it was only
a matter of time before he would be laid off by accounting firm Grant
Thornton.

"The writing was on the wall. I just didn't know
when," says Nelms, 36, who worked as senior internal auditor at the
company's Baltimore office for two-and-a-half-years. "Then I got the
e-mail."

By January he was out of a job and found himself at
a crossroads. Reluctant to jump back into the job market immediately, he
started exploring his options and stumbled upon the PhD Project, a nonprofit
that encourages minority business professionals to earn PhDs and go on to
become professors. He'd heard of the program back when he was an MBA student
at Howard University but had put it on the back burner after graduation.

"When D-day happened, I decided, well I can do one
of two things with my future: Either get a doctorate or look for a good old
dependable job," said Nelms, who got in contact with the PhD Project. A few
weeks later he applied and was accepted to the accounting PhD program at
Morgan State University in Baltimore, Md., where he'll be starting full-time
this fall. Says Nelms: "With a doctorate, I thought my destiny would be a
little more in my control."

Nelms is part of a growing wave of professionals
who are leaving the battered business world behind for a career in the
hallowed halls of academia. Applications are up substantially this year at
many top business PhD programs, with some business schools reporting jumps
in applications as high as 40%. PhD program directors attribute the jump to
professionals fleeing a weak job market, coupled with a surge of interest
from undergraduates bypassing that job market entirely to head straight for
school.

An Encouraging Sign Meanwhile, organizations like
the PhD Project say more people than ever before are expressing interest in
their programs and annual conference, which attracted the largest number of
participants in the organization's 15-year history this fall. It's an
encouraging sign for the world of management education, where a looming
faculty shortage has had B-school deans worried for years.

The surge of interest in becoming a business
professor comes just as a backlash is being felt among those in the business
community who hold MBAs, says Yuval Bar-Or, an adjunct at Johns Hopkins
University's Carey Business School and author of Is a PhD for Me? A
Cautionary Guide for Aspiring Doctoral Students, slated for release on May
19. Many fleeing the business world for academia may view it as a more
venerable profession, he says.

"MBAs are now persona non grata in many places, and
there is a fair amount of animosity being directed at them for living in the
fast lane, spending everyone's money, and not being responsible enough,"
Bar-Or says. "So business leaders, in society's eyes, have been knocked off
a pedestal, and that may be causing a lot of people with an interest in
business to want to go down a path that is more respected in society."

Those who have been thinking about getting a PhD
are not wasting any time exploring their options. Potential PhD students
were out in full force this fall at the PhD Project's annual conference in
Chicago last November, where attendees mingled with professors and deans
from nearly 100 business schools around the country. The conference usually
attracts around 330 people, but this year 832 people applied, about 534 of
whom were invited to attend.

"This was a substantial increase. It was so big
that we were starting to worry from a budgetary standpoint about how we were
going to pay for everything and if the room and hotel was going to be big
enough," said Bernie Milano, president of the PhD Project. He expects that
interest will continue to grow. He's already received 65 applications for
next year's conference, triple the amount he usually receives by this time
of year, he says.

Continued in article

Jensen Comment
There are a number of things working against an explosion of doctoral students
in accountancy. Firstly, the traditionally large accounting doctoral programs (Illinois,
Texas, Michigan, Indiana, Florida, Wisconsin, Ohio State, etc.) have greatly
shrunk in size since their days of glory before the "accountics" revolution
commenced in the 1960s. Shrinking departmental budgets will further dry up
funding going into doctoral programs and accounting research in general.
Generosity of hard-pressed accounting firms and alumni may also shrink private
donations that are often used heavily to fund endowed chair faculty and other
needs of doctoral programs.

Secondly, many jobless accountants with high GMAT scores often have
children and financial responsibilities and will be turned off by the five-year
average time it takes to get an accounting PhD, especially for jobless
applicants who have weak and or maybe forgotten accountics
prerequisites (calculus, advanced calculus, linear algebra, mathematical
statistics, econometrics, data mining, etc.) for which few have interest in
studying for five more years of their lives. Accounting doctoral programs now
have little to do with accounting and everything to do with making graduates
scientists in econometrics, mathematics, and psychometrics ---
http://www.trinity.edu/rjensen/theory01.htm#DoctoralPrograms

Thirdly, virtually all colleges and universities are now being forced
to downsize in some way due to shrinking budget allocations. Recovery of these
budgets will be slow long after the current recession turns around because of
the many demands placed upon states for other priorities such as Medicare and
expanded welfare that was only temporarily shrunk by the Clinton
Administration.. While expanding entitlements for poor people, President Obama
promises to eventually reduce the Federal deficit which means more and more of
the funding burdens will fall upon state taxation. Californians are now showing
the world that taxpayers are not in the mood for higher state taxes. I do not
anticipate that the shrinking doctoral programs in accountancy will get heavy
revival funding for years to come.

Fourthly, due to shrinking budgets and explosive growth in
undergraduate accountancy programs, virtually all colleges and universities,
with blessings from the AACSB, are creating full-time faculty positions for
former practitioners who do not have accounting doctoral degrees (although many
have law degrees or doctorates in other disciplines). These faculty reduce the
demand for more expensive graduates from accountancy doctoral programs. And this
is an outlet for early retirees who are great instructors with specialized
skills (e.g., ERP, auditing, and tax) that are more in line with undergraduate
teaching curricula in accountancy undergraduate and masters programs.

The new AICPA-sponsored fellowship program for doctoral students who elect
auditing and tax will help but the number of students funded in these
professional specialties is too small to have much of an impact on filling empty
tenure track positions. The KMPG Foundation fellowships for minority students
has helped to get more African Americans into accounting doctoral programs, but
I do not anticipate great increases in this funding source. The numerical impact
of both these dedicated programs will be very small among the thousands of
accountancy education programs in the United States.

There will be substantial increases in the doctoral programs in management,
marketing, MIS, and economics. Finance is a question mark since the number of
undergraduate students majoring in finance will greatly decline due to black
hole in job opportunities for graduates in finance. With declines in
undergraduate finance majors there will be less demand for newly-minted
professors of finance. Economics will probably fare better because the fact that
economics doctoral students on average only take three years beyond a bachelors
degree to complete the doctoral program. Three-year doctorates are drawing
cards to many returning jobless graduate students who do not want to spend more
than three years earning a doctorate. And there will probably be increased
opportunities for economists in Obama's exploding Federal government.
Purportedly increasing numbers of doctoral students in economics are looking
forward to civil service careers ---
http://www.trinity.edu/rjensen/Bookbob1.htm#careers

One other mitigating factor which could increase
space at PhD schools may happen “if” PhD students opt for leaving campus
“all but dissertation” due to the monetary attraction from schools who need
to fill faculty shortage positions.

Zane Swanson

May 21, 2009 reply from Bob Jensen

Hi Zane,

I think there are more reasons these days not to leave ABD until the
dissertation draft is completed and given preliminary approval by the
dissertation advisor. Firstly, most PhD programs provide financial
incentives to say on campus (e.g., assistantships for the first three or
four years and fellowships at the dissertation stage).

Secondly, most hiring schools place increased stress on dissertation
completion. Tenure clocks start running upon arrival at a new job whether or
not the dissertation is completed. Since publishing is more difficult for
ABD faculty concentrating on both teaching and thesis completion, this is a
huge incentive to delay startup of a new job.

Thirdly, student evaluation of instructors has become an enormous factor
in performance evaluation. A newly hired ABD tenure track professor cannot
shirk on teaching preparation and time spent with students. This factor has
changed greatly over the past few decades. In 1970 an ABD professor could
afford to spend less time on teaching until the dissertation was accepted.
Not anymore!

Of course there are many other factors that complicate matters. An ABD
candidate may follow a spouse to a new job. An ABD candidate may go beyond
five years when there is little financial support in the sixth year of a
doctoral program. Sometimes there is a new expected baby adding to financial
burdens.

Sadly, most excuses for working full time ABD become reasons for never
finishing the dissertation. This happens time and time again. The spouse of
a new professor at Trinity University in 2000 was herself ABD in
microbiology at the University of Illinois. She was ever so close to
finishing but decided to move with her husband to San Antonio and have two
new babies after moving. Her husband doubts that she will ever finish her
PhD degree since it’s especially difficult in science to take up where she
left off years ago. How many times have we heard similar stories about ABD
full-time teachers and ABD spouses who become full time parents?

Students with above-average scores on standardized
admissions tests are likely to get the greatest benefit from commercial test
preparation, according to a
new reportfrom the National Association for
College Admission Counseling.

Yet those benefits may not outweigh the costs for
many families, says the report's author, Derek C. Briggs, associate
professor of education at the University of Colorado at Boulder. "If there
are effects to be gained through preparation," Mr. Briggs said, "can you get
the same effect without spending the money? That's a pertinent question in
this economy."

Existing research suggests that coaching tends to
raise students' SAT scores by up to 30 points. Yet students cannot
necessarily attribute gains they might see to coaching alone, Mr. Briggs
says.

After all, students who take the test more than
once tend to see their scores increase anyway. So, Mr. Briggs suggests, some
students may raise their scores just as much by doing what he once did:
taking a series of practice tests in a relatively inexpensive book.

But even if test takers raise their scores by 30
points, would that make a difference in admissions? It may depend on the
scores they start with and the selectiveness of the colleges to which they
apply.

In his report, "Preparation for College Admission
Exams," Mr. Briggs examined to what extent such increases influence
admissions decisions. One third of colleges he surveyed agreed that in some
cases an increase of 20 points on the SAT's math section, or an increase of
10 points on the critical-reading section, would "significantly improve" an
applicant's chances.

The proportion of colleges that agreed with that
statement rose as the base SAT scores (the scores earned before the gains)
increased. That was especially true of more-selective colleges, where
applicants' scores fall in a relatively narrow range.

"If you come from a wealthy family and have high
scores to begin with and can spend $1,000, then test prep might be worth it
for those 30 points," Mr. Briggs said. "What's unfortunate is if
middle-class or poorer families think test prep is going to raise their
scores by 300 points. If you're a kid with scores between 400 to 500, I'm
not sure it's going to make any difference."

Seppy Basili, a vice president at Kaplan Test Prep
and Admissions, was concerned about what that conclusion might say to test
takers, particularly black and Hispanic students who, on average, do not
score as high as their white peers on the SAT. "I wouldn't want the message
to minority students to be that you can't benefit by preparing," said Mr.
Basili, who had not seen the report but was familiar with its findings.

Mr. Basili agreed that practice alone can help
students improve their scores, but he described effective test preparation
as something that also helps students analyze the mistakes they make on
exams and develop strategies for correcting them.

Yet Mr. Basili agreed with at least one of Mr.
Briggs's observations: the quality of test coaching, like anything else,
varies. "I would be the first to tell you that not all test prep is great,"
Mr. Basili said.

A research firm predicts 3,589 companies will report that
their auditors doubt they will continue as going concerns

The auditors of nearly one-quarter of companies
feel that the companies may not live out the year.

Auditors have become increasingly doubtful about
their clients' ability to continue as going concerns, according to the most
recent report on the subject by Audit Analytics, which has tracked the
number of such going-concern opinions this decade in a recently released
report. With calendar year-end 2008 filings still coming in to the
Securities and Exchange Commission, the research firm estimates there will
be 3,589 going-concern opinions eventually filed for 2008 annual reports, an
increase of 9% compared to last year's total of 3,293 going-concern
opinions.

Audit Analytics made this prediction based on a
compilation of regulatory filings made as of late March for 2008 10-Ks. Its
data suggests auditors' going-concern doubts were more commonplace compared
to the previous year. If the firm's estimate is correct, the number of
auditors' documented worries about their clients' viability will reach the
highest level this decade.

In 2001, 19.2% of companies noted their auditors'
going-concern uncertainty. But only 15% had those qualifications in 2003,
according to the Audit Analytics report. For 2007 10-Ks, that number rose to
20.9%, reflecting the highest number of going-concern doubts since 2000. Now
the total could reach 23.4% percent, the firm's researchers say.

The audit profession has been predicting a surge in
the number of going-concern doubts since last fall, when auditors were on
the verge of beginning their annual reviews for calendar year-end companies
amid the rough economy. Last month, on the heels of General Motors revealing
its auditors' going-concern doubts, Grant Thornton CEO Ed Nussbaum told
CFO.com there will be "an unprecedented number of going-concern footnote
disclosures and clarification from the auditors" forthcoming.

Auditors must consider several factors during their
annual client reviews that may signal that a company won't be in existence
12 months from now. Among them: negative recurring operating losses, working
capital deficiencies, loan defaults, unlikely prospects for more financing,
and work stoppages. Auditors also consider such external issues as legal
proceedings and the loss of a key customer or supplier.

Auditors' going-concern evaluations don't stop
there. If they have doubts about a company's future, they tend to confer
with their client's management and review the company's plans for overcoming
the problems noted and decide whether those plans can likely keep the
company in business. If they still aren't satisfied, then the auditors will
explain why they have "substantial doubt" about the company's ability to
stay a going concern in an opinion filed with the company's 10-K.

In late March, when Audit Analytics compiled the
data, only 10,895 auditor opinions had been filed for year-end 2008 with the
SEC. That means that Audit Analytics' forecast could be off, since the data
doesn't account for about 5,000 10-Ks that were still due. Still left to be
collected was data from smaller companies, late filers, and foreign filers.
But it's likely that companies that have missed the SEC's filing deadlines
are dealing with financial issues, possibly involving discussions over a
going-concern qualification with their auditors, suggests Don Whalen,
research director at Audit Analytics.

To be sure, what the findings mean has yet to be
determined . Still unclear is whether audit firms are being more
conservative in their forecasts because regulators have indicated they will
keep a close watch on going-concern opinions.

In the absence of any commitment to publish a
report and all the material at its disposal, the investigation will be
little more than cosmetic. The FSA's regulatory shortcomings are central to
the banking crisis. It presided over the development of a shadow banking
system and showed no inclination to regulate it. It allowed banks to publish
opaque accounts,
indulge in tax avoidance schemesand develop
dangerous financial products. It allowed banks to
run up
excessive leverage (pdf)and paid little attention
to the adequacy of their capital base. It allowed bank executives to collect
huge bonuses for mediocre performance. Its ideology of light regulation
curried favour with banking elites and paid little attention to the need to
protect citizens and society.

The FSA is seeking help from the "big four"
accounting firms – Deloitte, PricewaterhouseCoopers, KPMG and Ernst & Young
– for its investigation. This is a tacit admission that it does not have
in-house capacity to understand the accounting practices of banks. It could
not have diligently monitored the accounting practices of banks either
before or since the crisis. By relying on consultants, the FSA is unlikely
to build any institutional expertise and thus will not be in a position to
efficiently monitor banks now or in the future.

Almost all major banks are audited by one of the
"big four" accounting firms. They collected millions of pounds in audit and
consultancy fees, but none reported any financial problems before the
banking crash. There were plenty of warnings. For example, in September
2007, Northern Rock,
was relying on government help (pdf)for its
survival. In April 2007, New Century Financial, the second largest subprime
mortgage provider in the US,
filed for bankruptcy protection.

SUMMARY: At
Anheuser-Busch in St. Louis, Missouri, "...executives and others now
work a few feet apart" at clustered desks after new owners InBev
eliminated executive perks, demolished plush offices, and began
requiring sharing secretarial services. "...InBev has turned a
family-led company that spared little expense into one that is focused
entirely on cost-cutting and profit margins, while rethinking the way it
sells beer."

CLASSROOM APPLICATION: The
article includes a discussion of zero-based budgeting that can be used
in managerial accounting course covering the topic.

QUESTIONS:
1. (Introductory)
Who is InBev? How was the company formed? What iconic American beer
brands are now owned by this company?

2. (Introductory)
What cultural differences are evident between owners of InBev and
Anheuser-Busch? What factors do you think lead to these cultural
differences?

3. (Introductory)
How has InBev "focused on cost-cutting and profit margins"? Cite all
points in the article related to these strategies. In your answer,
define the term "profit margin" as it relates to the strategies being
undertaken.

4. (Advanced)
What is zero-based budgeting? How does that process help to focus on
cost-cutting efforts?

5. (Advanced)
What strategies indicate that InBev is "rethinking the way it sells
beer"? What evidence in the article indicates success in these efforts?
What arguments might refute the fact that strategy change accounts for
this improvement?

Construction crews arrived
at One Busch Place a few months ago and demolished the ornate executive
suites at Anheuser-Busch Cos. In their place the workers built a sea of
desks, where executives and others now work a few feet apart.

It is just one piece of a
sweeping makeover of the iconic American brewer by InBev, the Belgian
company that bought Anheuser-Busch last fall. In about six months, InBev has
turned a family-led company that spared little expense into one that is
focused intently on cost-cutting and profit margins, while rethinking the
way it sells beer.

The new owner has cut jobs,
revamped the compensation system and dropped perks that had made
Anheuser-Busch workers the envy of others in St. Louis. Managers accustomed
to flying first class or on company planes now fly coach. Freebies like
tickets to St. Louis Cardinals games are suddenly scarce.

Suppliers haven't been
spared the knife. The combined company, Anheuser-Busch InBev NV, has told
barley merchants, ad agencies and other vendors that it wants to take up to
120 days to pay bills. The brewer of Budweiser, a company with a rich
history of memorable ads, has tossed out some sports deals that were central
to marketing at the old Anheuser-Busch.

The changes have been tough
for workers to swallow. Some are grappling with heavier workloads, anxious
about job security and frustrated with the emphasis on penny-pinching, say
people close to the brewer. Former executives say workers feel less
appreciated in a no-frills culture with fewer perks.

InBev's response: It's more
effective to make "sweeping, dramatic changes" than incremental ones, said a
spokeswoman for the Belgian company, which has a history of many past
mergers and acquisitions. Asked if morale in the U.S. is suffering, Dave
Peacock, a 40-year-old Anheuser-Busch veteran who heads the U.S. division,
said, "I think there's probably some truth....Some people react very well,
some people struggle with it." Returning to the issue later in an interview,
he said the newly merged company "is like a start-up....That excites some
people and turns off others."

It isn't yet clear how well
the megadeal will pan out. The combination created the world's largest
brewer by sales. But the tumult could offer an opening for MillerCoors LLC,
which is exhorting its people to exploit the transition by trying to grab
more shelf space at large retailers.

Anheuser-Busch has nearly
half of the U.S. beer market. It got a stronger challenger last summer,
however, when SABMiller PLC and Molson Coors Brewing Co. linked their U.S.
divisions in the joint venture called MillerCoors, with 29% of the U.S.
market. "The next chapter in American beer is being written," MillerCoors
President Tom Long said at a conference last month.

Market-Share Gain But it was
Anheuser-Busch InBev that logged a market-share gain the first quarter of
this year, an increase of about three-quarters of a percentage point at
sales at retail stores excluding Wal-Mart Stores Inc. The figures, from
Information Resources Inc., show Anheuser-Busch InBev lifting its U.S. beer
sales 5.7% in dollar terms from a year earlier. Bars and restaurants aren't
included.

The U.S. market is holding
up well despite the recession, Anheuser-Busch InBev Chief Executive Carlos
Brito said Tuesday. "In tough times, it's a great market to be exposed to,"
Mr. Brito, 48, said at a news conference after the company's annual meeting
in Brussels. He declined to be interviewed for this article.

InBev emerged as a beer
heavyweight five years ago through the linkup of Brazil's AmBev, known for
Brahma beer, and the Belgian producer of Stella Artois, Interbrew SA. Though
it was based in Leuven, Belgium, the Brazilians' culture came to dominate.
That approach stresses a sharp eye on costs and incentive-based pay
structures.

InBev eschews fancy offices
and company cars, and groups of its executives share a single secretary. It
uses zero-based budgeting -- meaning all expenses must be justified each
year, not just increases. The company says it saved €250,000 ($325,000) by
telling employees in the U.K. to use double-sided black-and-white printing,
spending the money to hire more salespeople.

"We always say, the leaner
the business, the more money we'll have at the end of the year to share,"
Mr. Brito, the CEO, said in a speech last year to students at his alma
mater, Stanford University business school.

Anheuser-Busch took a
different path, spending amply on everything from top beer ingredients to
the best hotel accommodations. Executives didn't just have secretaries --
many also had executive assistants, who traveled with their bosses, took
notes and learned the business in a kind of apprenticeship.

Most employees, even those
at the company's Sea World and Busch Gardens theme parks, got free beer.
Once the owner of the St. Louis Cardinals, the company continued to shell
out heavily for tickets to Cardinals games, used in marketing. Employees who
wanted the company to donate beer or merchandise for community events faced
little red tape. The St. Louis company often made "best places to work"
lists.

Heavy ad spending on sports
events, often as the exclusive beer advertiser, helped Anheuser-Busch become
the U.S.'s dominant brewer. But its growth and stock performance turned
sluggish in recent years as U.S. sales of imports and small-batch "craft"
beers rose faster than the St. Louis giant's brands.

After InBev swooped in last
fall with a $52 billion takeover, it sacked about 1,400 employees in the
U.S., equal to 6% of the U.S. work force before the merger, and 415
contractor positions. These followed 1,000 employee buyouts accepted at
Anheuser-Busch just before the merger.

InBev has overhauled the
U.S. division's compensation system for salaried employees, as part of what
an internal memo called "an increased focus on meritocracy." In the future,
the company will pay salaried workers 80% to 100% of the market rate for
comparable jobs, "and any increases above that require special justification
and approvals," said the memo. That changed a system in which "high
performers...might have seen fewer rewards as dollars were spread more
evenly."

SUMMARY: "Borrowing
against receivables isn't new. For hundreds of years, cash-strapped
companies have hired...factors to advance them funds based on money owed by
customers....A few companies are [offering]...products and services designed
to make the process of borrowing against customer invoices cheaper and more
transparent." One example of a company using these services is Data Drive
Thru, Inc., a young start up that has made it to selling to big box stores
such as Staples,. CFO Brad Oldham says, "Retailers may not be real fast
paying, but they do pay." Data Drive Thru posts its invoices on Receivables
Exchange LLC, which can be thought of as "eBay for receivables...Lenders
then peruse the site, searching for receivables against which they are
willing to lend. Lenders bid on those invoices, with the majority electing a
fixed buyout price similar to eBay's 'buy it now' feature." Factoring can be
expensive though less so on this facility than traditional past practices.
Further, other companies have joined the market to provide verification
services for the receivables being factored.

CLASSROOM APPLICATION: Covering
the unusual topic of factoring can be brought to "cyber" life with this
article.

QUESTIONS:
1. (Introductory)
What is factoring of receivables? What journal entries are recorded when
factoring receivables?

2. (Advanced)
How expensive is it to factor receivables? In your answer, quote one rate
given in the article and express the rate as an annual interest rate.

3. (Introductory)
Why do companies undertake factoring as a means of obtaining cash if it is
so expensive?

4. (Advanced)
What is "transparency" in the process of factoring receivables?
Specifically, cite examples in the article of activities that help provide
this quality in these financing transactions.

5. (Advanced)
Refer to the chart showing the average number of days it takes private
companies to collect money owed by customers. How is this statistic
calculated? Be specific, including the source of the financial data for the
calculation.

SUMMARY: Glenn
Beck, in a wide-ranging contract with Simon & Schuster, will accept
smaller book advances in exchange for a share in the profits. The
arrangement lets Simon & Schuster experiment with formats, genres and
categories because there is less cost up front in an uncertain market,
giving the author the comfort of knowing he'll be compensated if sales
go up, while also protecting the company.

CLASSROOM APPLICATION: This
article is a good illustration of a business incorporating fixed and
variable cost information in strategic management decisions. You can
discuss the traditional model of a higher advance vs. this new approach
of reducing fixed costs to address the challenges in the current
recession and state of the book industry.

QUESTIONS:
1. (Advanced)
What are fixed costs? What are variable costs? Why do managers need to
be aware of the differences? How do these costs impact planning and
budgeting?

2. (Introductory)
How are fixed costs impacted by this new arrangement? How are variable
costs changed in this new arrangement?

3. (Introductory)
In what situations are low fixed costs and high variable costs favorable
for a company? When are high fixed costs and low variable costs more
favorable?

4. (Advanced)
What are the benefits for the publisher with this new deal? What are the
benefits to the author? Which arrangement - high or low fixed costs -
seems to be better for the publisher? What arrangement is better for an
author? As a publisher, what factors would you take into consideration
in deciding whether to offer this kind of deal? As an author, what
factors would you consider?

5. (Advanced)
Why is this particular compensation arrangement so important in the
current economy? Do you think that this type of deal will be similarly
attractive when the economy rebounds? Why or why not?

6. (Introductory)
From a financial accounting standpoint, how would the publishing company
book an advance? What would be the journal entries at the time of
contract and at the time of payment? Would there be any adjusting
entries involved? Why or why not? If so, what would they be?

7. (Advanced)
What other industries or businesses could benefit from a change in cost
structure? Give several specific examples and explain why they should
change.

Author and talk-show host Glenn Beck has signed a
wide-ranging contract with CBS Corp.'s Simon & Schuster publishing arm that
gives him profit participation in each new book, a perk the publisher has
traditionally reserved solely for its most important writers, such as
Stephen King.

The deal reduces the publisher's risk by paring Mr.
Beck's advances at a time when the book business is rocky.

The move also locks in an author whose media
presence has helped make him a best-selling writer. According to Simon &
Schuster, Mr. Beck's first book, the 2003 nonfiction work "The Real
America," sold 50,000 hardcovers; 2007's nonfiction "An Inconvenient Book"
sold 500,000 hardcovers; and his novel "The Christmas Sweater," published in
2008, sold 775,000 hardcovers.

Authors typically receive a royalty of 15% of the
publisher's suggested retail price on hardcover titles and a 7% to 10%
royalty on paperbacks, money paid out after publishers have recouped their
advance. Mr. Beck will accept smaller advances in exchange for a share in
the profits. The deal will also provide him with more creative control over
how his books are designed and marketed.

"I'd rather take a lower advance and have a
partnership," Mr. Beck, 45 years old, said. "I'll bet on myself and a smart
person on the other side of the table every time." Mr. Beck said he took
satisfaction in having a deal similar to that of Mr. King, noting that Mr.
King described him in a magazine column as "Satan's mentally challenged
younger brother."

This year, Mr. Beck will offer three new titles:
"America's March to Socialism," which will be issued in May as an original
audiobook read by the author; "Glenn Beck's Common Sense," which will be
published as an ebook original in June and later as a fancy paperback; and
"Arguing with Idiots," a nonfiction title that arrives in September from
Simon & Schuster's Threshold Editions. A children's picture book of "The
Christmas Sweater" is also expected to hit bookshelves this fall.

The arrangement lets Simon & Schuster experiment
with formats, genres and categories because there is less cost up front,
said Carolyn Reidy, CEO of Simon & Schuster. "In an uncertain market, it
gives the author the comfort of knowing he'll be compensated if sales go up,
while also giving us protection," she said.

Mr. Beck's radio show, "The Glenn Beck Program," is
syndicated nationwide. His eponymous talk show on the Fox News Channel,
which premiered in January, draws an average of 2.2 million viewers,
according to Nielsen Co. Fox is owned by News Corp., which also owns The
Wall Street Journal publisher Dow Jones & Co. "There was a time when I had
to explain who he was," said Louise Burke, publisher of Simon & Schuster's
Pocket Books imprint, which issued his first book. "That's no longer the
case."

How to account for inventory loans with clawback provisions?

From The Wall Street
Journal Accounting Weekly Review on April 30, 2009

SUMMARY: Chrysler
and GM auto dealers are facing worries over slow sales and possible debt
calls on their inventory loans due to falling values of these U.S. auto
makers' brands. This discussion of the domino-effect of U.S. automakers'
bankruptcies focuses on the impact on car dealers' financing of vehicle
inventories.

CLASSROOM APPLICATION: The
article can be used in financial or managerial accounting courses covering
inventories and current liabilities, from the introductory level up.

QUESTIONS:
1. (Introductory)
What are 'wholesale loans' or 'floorplan financing' arrangements for car
dealerships? From where do car dealerships obtain these loans?

2. (Advanced)
Are these inventory-financing loans short-term debt or long-term? Support
your answer.

3. (Introductory)
Why does the looming bankruptcy of the U.S. car makers Chrysler LLC and
General Motors Corp. lead to potential calls for immediate repayment, in
full or in part, of loans owed by car dealership companies?

4. (Advanced)
Why might such debt repayment be required in the case of bankruptcy
proceedings? In your answer, provide an overview of the overall bankruptcy
process that might lead to this result.

For Chrysler LLC and General Motors Corp.
dealerships, slow sales are just part of their worries. Now they're bracing
for possible auto-maker bankruptcy filings that could trigger repayment of
their inventory loans.

The two auto makers have about 10,000 dealers in
the U.S., with the bulk of them carrying considerable debt, mainly from the
money they borrow to buy cars that sit on their lots. If Chrysler or GM were
to file for bankruptcy protection, the banks extending that credit could
immediately begin calling dealer loans, demanding a good portion of the
money back and refusing to extend any more inventory financing.

U.S. taxpayers, meanwhile, could be called to the
rescue.

At issue are loans for inventory, known as
"wholesale" loans or "floorplan" financing, that are primarily given by GMAC
LLC and Chrysler Financial to dealers so they can buy vehicles to stock
their showrooms. These loans are typically backed by the vehicles that are
being financed by the dealer and paid back when the vehicles are sold.

Chrysler Financial and GMAC, run independently and
answering to different shareholders, have "clawback" provisions that allow
the finance companies to demand at least partial payment of the loans in the
event of a bankruptcy because the value of the vehicles being used as
collateral would plummet. Other lenders are believed to have similar
provisions.

Last week, the National Automobile Dealers
Association met with the Treasury's task force on the auto industry to talk
about the issue, particularly as it pertains to Chrysler, but walked away
without a solution, NADA Chairman John McEleney said.

"It's a huge problem that we don't have the answer
to," Mr. McEleney said in a telephone interview late last week. "I feel a
little better because the task force seems to understand."

Mr. McEleney said NADA is looking for some
guarantees from the Obama administration that would help prevent dealer
failures that could result from the clawback provisions.

An Obama administration official briefed on the
meeting said "it was a good discussion and a thoughtful exchange, but
certainly there was no commitment.

On Monday, GM President and CEO Fritz Henderson is
scheduled to present an update on the company's revised viability plan. Mr.
Henderson is expected to announce further reductions of plants and brands,
including the iconic Pontiac brand, and GM could launch a debt-for-equity
exchange with unsecured bondholders who are owed about $28 billion. The
exchange must commence Monday in order to avoid default on a $1 billion loan
that is due for payment June 1.

GM also needs to make progress on cutting hourly
labor costs, and reducing the amount of cash it owes United Auto Worker
retirees for future health-care obligations.

The administration is faced with a balancing act in
how it should help the thousands of dealers selling GM and Chrysler
vehicles, just as it does with auto-parts makers..

On the one hand, bankruptcy would be a way to help
the two U.S. companies outmaneuver uncompetitive supply contracts with parts
makers and onerous state franchise laws that protect underperforming dealers
from being closed down.

Just as Treasury officials have demanded major
concessions from the UAW and bondholders, they are also calling for a sharp
decrease in the amount of dealers and suppliers connected to GM and
Chrysler.

But completely ignoring their plight could lead to
a unintended collapse of the whole network of companies dependent on the two
companies, and that could lead to tens of thousands of job losses in coming
months at the auto-parts companies, and dealers. Auto suppliers received a
$5 billion aid package from Treasury in March. Treasury officials also
designed a government warranty program for GM and Chrysler dealers so that
buyers would feel safer buying cars from two companies on the edge of
collapse.

Traditionally, three-quarters of the dealers at
both Chrysler and GM finance their inventories through GMAC or Chrysler
Financial because those companies typically make wholesale loans the top
priority when it comes to auto-industry lending, and because credit is
typically extended at a discount rate.

A person familiar with Chrysler Financial's
position on the clawback provision said the company will work with each
dealer on a case-by-case basis.

GMAC alone currently extends over $20 billion in
wholesale financing to U.S. dealers for inventory purposes.

GM, in documents filed in February with the
Treasury , said direct financing to dealers for inventory could end up
costing taxpayers between $2 billion and $14 billion over the course of the
company's stay in bankruptcy, should a Chapter 11 filing come to pass.
Chrysler's projection on the matter is unclear.

As of the end of the first quarter, GM and Chrysler
dealers had 1.1 million vehicles of unsold inventory on their lots. The two
companies sold 660,000 vehicles during the entire first quarter, and there
is little indication that an uptick in sales will help clear the inventory.

The administration's auto task force has been
considering indirect ways of helping dealers, such as measures that would
allow GM and Chrysler to once again offer leases on new vehicles, something
they stopped doing last summer, people familiar with the matter said. They
are also looking at how the auto makers can trim dealer networks.

Principles-Based Accounting Standard Question
FASB accounting standards are more rule-based than their international IASB
counterparts that are more principles-based. The above case is an excellent test
of whether principles-based standards will lead to more consistency in how to
account for such inventory loans when the rules-based standards are somewhat
difficult to apply. In other words, would international standards lead to more
consistency regarding how automobile manufacturers and dealers account for
inventory loans with "clawback" provisions?

The Securities and Exchange Commission on Tuesday
charged a securities salesman and a portfolio manager with insider trading
in the first such case involving credit default swaps.

The SEC alleges that Jon-Paul Rorech, a salesman at
Deutsche Bank Securities Inc., tipped off Renato Negrin, a former portfolio
manager at hedge fund investment adviser Millennium Partners LP, about a
possible change in terms of a bond being issued by VNU NV, a Dutch
publishing company that owns Nielsen Media and other media businesses, in
2006. Deutsche Bank was acting as the lead underwriter of the VNU bond
issuance.

With knowledge of the potential change in bond
terms, Negrin purchased credit default swaps on VNU for a Millennium hedge
fund, according to the SEC complaint. After news of the bond terms was
released, Negrin sold the swaps at a profit of $1.2 million, according to
the SEC.

Credit default swaps are an insurance-like contract
that protects a buyer from potential losses that might be incurred on an
underlying financial investment, such as a corporate bond or mortgage-backed
security. Many of those types of underlying investments have lost much of
their value or increasingly defaulted amid the credit crisis.

If the underlying financial investment is not
repaid, the buyer of the swap is covered in full for the losses through the
swap.

Credit default swaps have been widely seen as one
of the major factors in the credit crisis. The trading of swaps helped push
Lehman Brothers Holdings Inc. into bankruptcy protection and American
International Group Inc. the to brink of failure before being bailed out by
the government.

Richard Strassberg, a lawyer representing Rorech,
said in a statement that his client acted "consistently with the accepted
practice in the industry." Strassberg said Rorech did not violate any
securities laws tied to the sale of the VNU bonds.

A lawyer for Negrin was not immediately available
to comment on the case.

The SEC is asking for the judge to force the two to
repay the money gained from the transaction, plus penalties and back
interest on the allegedly ill-gotten gains.

The SEC's hedge fund working group handled the
investigation. The group has brought more than 100 cases alleging fraud and
manipulation by hedge funds over the past five years, including more than 20
in 2009.

"Journalist Gillian Tett warned about the
problems in the financial industry long before many of her
colleagues. In her new book, Fool's Gold, Tett examines the role
J.P. Morgan played in creating and marketing risky and complex
financial products"

"The
first sign that there might be a structural problem with the
innovative bundles of credit derivatives that bankers at JP Morgan
had dreamed up emerged in the second half of 1998. In the preceding
months, Blythe Masters and Bill Demchak – key members of JP Morgan’s
credit derivatives team – had been pestering financial regulators.
They believed that by using the new credit derivative products they
had helped create, JP Morgan could better manage the risks in its
portfolio of loans to companies, and thereby reduce the amount of
capital it needed to put aside to cover possible defaults. The
question was by how much. (Though these bundles of credit
derivatives later went under other names, such as collateralised
debt obligations [CDOs], at that time these pioneering structures
were known as “Bistro” deals, short for Broad Index Secured Trust
Offering). Masters and Demchak had done the first couple of Bistro
deals on behalf of their own bank without knowing the answer to
their question for sure. But when they were doing these deals for
other banks, the question of reserve capital became more important –
the others were mainly interested in cutting their reserve
requirements."

College tuition prices keep rising. State budgets
are stagnant or shrinking. And policy makers, from President Obama on down,
are increasingly calling for increases in the number of Americans who get
some higher education or training.

Those factors have led more state legislators,
trustees and others to argue that, to accomplish the latter goal given the
former circumstances, colleges are going to have to lower what they spend to
produce the average credential they award. But any discussion of lowering
the "cost per degree" must start with a more fundamental question: What does
a degree cost to produce now?

That question may be basic, but it is not simple,
as
a new reportfrom the Delta Project on
Postsecondary Education Costs, Productivity, and Accountability makes clear.
The paper, prepared by Nate Johnson, associate director of institutional
planning and research at the University of Florida, lays out a range of
possible approaches to calculating the cost of a college degree and then
calculates them using a rich set of data from the State University System of
Florida, where Johnson formerly worked.

The paper shows that it is distinctly possible to
come up with such a figure, but the wide variation in the numbers -- based
on institution type, program, degree level, and other factors -- suggests
that the answer will depend in large part on how the question is framed. And
that decision is a surprisingly value-laden one, says Johnson. "You frame
the question one way if you are only interested in students who graduate,
and another way if you want to know the cost for people who go to college
and don't complete," he says. "The point is, this is not just a data
question. It's a question of what it is that we want from our colleges and
universities."

The broad work of the Delta Project and its
founder, Jane Wellman, is to analyze the "spending side" of the higher
education cost and price picture; the group has released a series of reports
that try to document the interplay of colleges' revenues and expenditures,
and how those trends affect what they charge to students. The new study,
which grew out of Johnson's work in Florida, he says, aims to develop a
"common language," if not a common format, for focusing the discussion about
how one might measure the cost of a degree in a particular institution,
system or state. Toward that end, Johnson proposes several possible ways of
calculating the average cost of a degree.

The analyses are based on data showing that the
Florida university system incurred an average of $288 in direct and indirect
instructional expenditures per credit hour, with wide variation by level
($188 for lower division undergraduate, $537 for master's, etc.),
institution ($240 for an upper level undergraduate credit at the massive
University of Central Florida, $677 for the same credit at the 700-student
New College), and field of study ($159 in family/consumer sciences, $509 for
natural resources/conservation). The analysis counts only those expenditures
derived from state appropriations and student tuition, excluding endowment
and other funds.

The first estimate, which Johnson calls the
"catalog cost," calculates what a college would spend to educate a student
who fulfills the "catalog requirements" of the average degree to the letter
-- no more, no less. (The equation: cost per credit hour x instructional
expenditures/credit hours.) The average cost is $26,485, with institutions
within the Florida system ranging from $22,440 to nearly double that.
Johnson also found significant variation by field because of vastly
different requirements and program length, with mechanical engineering
averaging $37,870 vs. $27,159 for elementary education.

The catalog method is easily understood, but it
"does not reflect actual student behavior," Johnson notes. More accurate in
gauging how students actually maneuver through institutions, he writes, is
the "transcript method" of cost analysis, in which the total number of
credit hours students take are multiplied by the cost per credit hour, and
then divided by the number of degrees awarded. The average freshman who
entered a Florida system university and graduated in 2003-4 "attempted" 131
credits, including failed or withdrawn courses and subtracting for any AP or
dual enrollment courses that reduced their course requirements.

The average "transcript cost," then, was $31,763;
converting to 2006 dollars, to make parallel to the figures from the
"catalog cost" analysis, Johnson writes, the average figure is $33,672. (The
2003-4 figure for mechanical engineering was $47,257.)

Both the catalog and transcript cost methods factor
into the calculation only those costs incurred by students who actually
graduate. The third major analysis, "full cost attribution," examines the
entire amount that an institution or system spent on instructional purposes
to achieve an "aggregate level of degree completion." The equation looks
like this: all credits taken at an institution over three years x the
three-year average cost per credit hour/three years of degrees.

Not surprisingly, because all courses taken by all
students would be allocated to the smaller proportion who actually earned
degrees, this produces the highest cost per degree number; $37,757 in 2002-3
dollars, equivalent to $40,645 in 2005-6, Johnson writes. This analysis
grows less predictable and valid the more narrowly it is drawn, he adds,
because programs with high attrition, or into which many students transfer
late in the game, can have their figures drastically altered. The overall
high and low for the Florida university system, for example, were $170,831
for "multidisciplinary studies" and $21,473 for parks and recreation, and
the variation by degree level was enormous: $33,425 for a law degree,
$259,781 for an M.D., and $121,725 for a doctorate.

So which is the most accurate assessment of what a
university spends to educate a graduate? The catalog cost of $26,485, the
transcript cost of $33,672, or the "full cost" $40,645? The last is
"probably closer to an answer" to the question that policy makers are
increasingly asking now, about "what would we have to spend to get more
graduates," though that assumes that colleges maintained their current
enrollment and expenditure levels, he notes.

But the other key point, Johnson says, is that the
choice of how you measure cost depends, to an extent, on how you perceive
the role of colleges. Using the "full cost" measure, he asserts, more or
less says that most of what a university does is designed to educate
students, and that "all of those costs could be attributed to the cost of
producing college graduates," as overhead, he says.

"If you highly value research or public service,"
though, "you could almost say that the graduates are free -- a byproduct" of
what you spend on those other purposes.

The big news is the possible side tracking of the Herz-Cox
Express Train for replacing U.S. accounting standards (FASB rules) with
international standards (IFRS) in 2014. The rush to re-educate and retrain
accountants in the United States is now give a more reasonable time frame. The
rush filing gaps in international GAAP has been give a more reasonable time
frame. There is now more time for the International Accounting Standards Board
to obtain better funding and to improve its infrastructure, especially its
research budget and staff.

In preparation for a May 14th
talk at Florida State, i have assembled a wiki,
http://ficpa-ifrs.wikispaces.com/where i have
posted several recent articles about the SEC IFRS roadmap. Please feel free
to visit, join the wiki and contribute to the materials assembled. Thanks,

Neal Hannon

The other big news items were the the infamous fair value accounting FASB
Staff Positions (FSPs) announced on April 2, 2009. This
relaxation/reinterpretation of fair value definitions and impairment testing
arose largely out of political pressures and accusations that fair value
accounting rules played a large role in the banking crisis of 2008 and recovery
in 2009.

• FSP FAS 157-4, Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly ("FSP FAS
157-4") ---
http://www.fasb.org/pdf/fsp_fas157-4.pdf

The Deloitte letter to the IASB provides our
detailed views on each of the final FASB
Staff Positions and contrasts them with
IFRSs. Here are two excerpts from our
letter:

Regarding FAS 157-4, the
Deloitte letter to the IASB
states:
We believe that the FASB Staff
Position FAS 157-4 is broadly
consistent with the principles
of fair value in IFRSs and the
Expert Advisory Panel document
and therefore an amendment to
IFRSs is not necessary. However,
in light of the IASB's imminent
release of an exposure draft on
Fair Value Measurements, the
IASB should consider whether the
words used in the FASB Staff
Position FAS 157-4 are
consistent with the exposure
draft and whether the wording of
the exposure draft should be
aligned with the FASB Staff
Position FAS 157-4. In addition,
the IASB should seek the views
of the Expert Advisory Panel to
establish whether differences in
the words of the FASB Staff
Position FAS 157-4 and the
Expert Advisory Panel report are
expected to have any practical
effect.

Regarding FAS 115-2 and 124-2,
the Deloitte letter to the IASB
states:
As noted in the request for
views, the differences between
U.S. GAAP and IFRSs with respect
to scope, impairment triggers,
impairment measurements, and
recoveries are numerous and
complex. A short term project to
fully converge with FASB's
amendment would entail
substantial changes to IFRSs
that would require significant
efforts and would create
unnecessary complexities (e.g.,
recognizing impairments of
held-to-maturity securities that
are not due to credit in other
comprehensive income). Instead,
we would encourage both Boards
to expedite their work on a
joint standard that would
improve reporting for all
financial instruments including
impairment issues (e.g., loss
recognition triggers,
measurement of losses,
recognition of recoveries,
etc.).

In deciding not to adopt FSP FAS
115-2 and FAS 124-2, the IASB said that, instead, it will take up the broad
issue of impairment as part of its
Comprehensive Review of IAS 39. The
IASB believes that an immediate response to the recent FSP on impairment is
unnecessary. The IASB also announced a timetable for the IAS 39 review,
which calls for issuance of an exposure draft of a proposed replacement for
IAS 39 by October 2009.

Question
What impact does the infamous FSB easing of fair value accounting rules have on
bank earnings?

Answer
We anticipated that banks would show higher valued assets and capital reserves
(due to less write down of sick investments) and higher earnings due to not
having to write down toxic investments so deeply --- http://www.fasb.org/news/nr040909.shtml
Almost everybody, including the banks themselves, claims that the rosy
first-quarter earnings of the the large U.S. banks cannot be sustained. Bank of
America discovered that rosy earnings alone will not lure (read that sucker)
investors into buying into poisoned banks. Of course not all the jump in
earnings is due to the change in FASB rules for fair value accounting. Much of
the earnings jump is due to a spike in re-financing of real estate mortgages
after the Fed eased mortgage rates to historic lows. Banks cannot count on this
re-financing surge in revenues to continue.

Wells Fargo yesterday showed the potentially
dramatic impact of the recent loosening of accounting rules as it reported a
first-quarter profit of $3.05 billion.

The San Francisco company said the accounting
change, which has generated controversy, allowed it to increase capital
reserves by more than $4 billion. The increase could make a critical
difference in the federal government's evaluation of the company's ability
to withstand a deepening recession, accounting experts said.

"This makes them look a lot healthier in the eyes
of the government and presumably other observers as well," said Robert
Willens, who advises financial companies on tax and accounting issues. "And
you would think therefore that they will have passed the stress test with
flying colors."

Wells Fargo reported that first-quarter earnings
fell 7 percent to 56 cents a share, from 60 cents a share or $2 billion
during the first quarter of last year. The company had issued an unusual
statement two weeks ago disclosing its bottom line but offering little
explanation of how the result was achieved.

Yesterday, the company said its retail banking
operations had outperformed those of its major rivals, Bank of America and
J.P. Morgan Chase, in significant part because of Wells Fargo's position as
the nation's largest mortgage lender. The company's income from mortgage
lending surged fourfold to $2.5 billion as it benefited from a refinancing
boom driven by federal efforts to hold down interest rates.

Wells Fargo took an investment of $25 billion from
the Treasury Department. It also is the major beneficiary of a change in
federal tax law last fall that shelters billions of dollars of its own
profits from taxes based on losses incurred by Wachovia, the troubled bank
it bought in December. The deal made Wells Fargo the largest banking firm in
the Washington region by number of branches.

The Financial Accounting Standards Board, under
intense pressure from banks and Congress, agreed in early April to let banks
report higher values for some assets. Most large banks have made a point of
saying that their results were achieved without this kind of accounting
adjustment. Wells Fargo's action, however, underscored the room for maneuver
available to other banks in future quarters.

Wells Fargo had set aside almost $10 billion from
its capital, the pool of money banks are required to maintain as a reserve,
to reflect a decline in the value of its investments. The decline was based
on the prices that buyers were paying for similar assets. After the FASB
change, which allows banks to substitute their own judgment in some cases,
Wells Fargo decided market prices were too low by more than $4 billion, and
it returned that amount to its capital pool.

Will large auditing firms survive their professional failures and suspected
non-independence prior to the bank failures and other corporate bankruptcies?
The spate of shareholder and creditor lawsuits have already commenced and some
of the claims are enormous ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Auditors

SUMMARY: A
new FASB standard requires companies to disclose income related to
minority stakes in other firms. U.S. accounting-standard setters threw
some observers of corporate profits a curveball this earnings season by
fiddling with what companies mean by "net income." It requires companies
to disclose income related to so-called noncontrolling interests --
investments in other firms in which a company owns only a minority
stake. That would make such income easier to see and bring U.S. rules
more into line with international accounting standards.

CLASSROOM APPLICATION: This
article helps to notify students of the coming changes to the income
statement. It also can serve as a basis for discussion regarding the
role of the FASB and how changes to many aspects of accounting are
possible. Finally, the mention of international accounting standards can
generate some discussion about the differences between the U.S. system
and systems in other countries, as well as the changes on the horizon.

QUESTIONS:
1. (Introductory)
What is the FASB? What is its authority and it corresponding
responsibilities? Who is on the FASB?

2. (Advanced)
What is the change that the FASB is making to financial statements? Why
is the FASB making these changes? How will the changes impact U.S.
corporations from a practical standpoint?

3. (Introductory)
What are the benefits of the changes? What are some of the problems that
could come from these changes? Do you think that these changes will
achieve the goals of the FASB in this instance? Why or why not?

4. (Introductory)
How will The Wall Street Journal report net income in the future? Why
would The Journal take that approach?

5. (Advanced)
The article states that the change would bring U.S. rules more in line
with international accounting standards. Why is that important? Why is
accounting in the U.S. different from that in other countries? Should
the rules be the same throughout the world? Why or why not? What changes
are on the horizon?

U.S. accounting-standard
setters threw some observers of corporate profits a curveball this earnings
season by fiddling with what companies mean by "net income."

The decision to replace the
time-honored bottom line -- the most basic measurement of corporate
performance -- with formulations like "net income attributable to the
company" has changed the familiar look of earnings statements at a time when
corporate profits are being closely scrutinized for signs of the economy's
health.

The move by the Financial
Accounting Standards Board is aimed at giving investors more detail about
companies' investments. But E.J. Atorino, a media and publishing analyst for
Benchmark Research, said the improvement is marginal at best.

"I think these accountants
have gone crazy," he said. "They're just making life more complicated."

A FASB spokesman declined to
comment. The changes are a result of Financial Accounting Standard 160,
which took effect with the first quarter for most companies. It requires
companies to disclose income related to so-called noncontrolling interests
-- investments in other firms in which a company owns only a minority stake.
That would make such income easier to see and bring U.S. rules more into
line with international accounting standards.

So far so good. But the
change also requires companies to report net income before and after income
from noncontrolling interests. As a result, "net income" is no longer the
bottom line.

What used to be simply
called "net income" at a company holding minority stakes is now called "net
income attributable to" the parent company -- even though it is the same
figure, calculated the same way. The presentation and terminology change,
but not the numbers themselves.

For instance, McGraw-Hill
Cos. on Tuesday reported first-quarter "net income" of $66.0 million. It
then deducted $3 million from noncontrolling interests and reported "net
income attributable to The McGraw-Hill Companies, Inc." of $63 million --
compared with $81.1 million a year earlier. That $81.1 million was
originally reported last year as simply "net income."

Colgate-Palmolive Co.,
seeking to avoid possible confusion when it reported earnings Thursday, took
a different tack. It started with "net income including noncontrolling
interests," allowing it to keep "net income" as its bottom line. Colgate
spokeswoman Hope Spiller said the company chose the wording for the purpose
of "simplicity and consistency."

When writing about corporate
earnings, The Wall Street Journal will focus on "net income attributable" to
the company or the equivalent. Earnings per share -- the figure closely
watched by analysts -- are also based on the "attributable" number.

The change has no
effect on the bottom-line number, as companies have always excluded income
from minority stakes. There may be a greater effect on the balance sheet,
however, where noncontrolling interests will now figure into calculations of
shareholder equity.

Corrections and Amplifications:

A company's "noncontrolling interests" are
minority stakes in its subsidiaries that are owned by outside parties. This
article incorrectly defined noncontrolling interests as investments in other
firms in which a company owns only a minority stake.

Question
Why did Morgan Stanley lower first quarter earnings because the credit spreads
on some of its long-term debt had narrowed?

Paragraph 15 of FAS 157

Application to liabilities
15. A fair value measurement assumes that the liability is transferred to a
market participant at the measurement date (the liability to the
counterparty continues; it is not settled) and that the nonperformance risk
relating to that liability is the same before and after its transfer.
Nonperformance risk refers to the risk that the obligation will not be
fulfilled and affects the value at which the liability is transferred.
Therefore, the fair value of the liability
shall reflect the nonperformance risk relating to that liability.
Nonperformance risk includes but may not be limited to the reporting
entity’s own credit risk. The reporting entity
shall consider the effect of its credit risk (credit standing) on the fair
value of the liability in all periods in which the liability is measured at
fair value. That effect may differ depending on the liability, for example,
whether the liability is an obligation to deliver cash (a financial
liability) or an obligation to deliver goods or services (a nonfinancial
liability), and the terms of credit enhancements related to the liability,
if any.

In
finance, a credit spread is the
yield spread, or difference in
yieldbetween different
securities, due to different
credit quality. The credit spread reflects the additional
net yield an investor can earn from a security with more
credit riskrelative to one with
less credit risk. The credit spread of a particular security
is often quoted in relation to the yield on a
credit risk-freebenchmark
security or reference rate.

Reduced credit spread on a bond investment
ceteris paribus increases market value of a bond and, thereby, results higher
unrealized earnings due to mark-to-market upward adjustment of an asset. Reduced
credit spread on a liability has the opposite impact on earnings for the
unrealized loss due to a mark-to-market adjustment that increases the fair value
of the liability. This is a bit confusing, since by reducing credit risk on
their debt, debtors take an earnings hit when adjusting the debt to fair value.

As if
they needed any, the critics of fair value got a fresh new example of the
craziness of an oft-decried provision in FAS 157, paragraph 15 of Fair Value
Measurements. The provision rewards companies whose credit spreads on their
debt liabilities have widened and punishes those who have become more
creditworthy.

On Wednesday, Morgan Stanley reported that it had
to cut its first-quarter net revenues $1.5 billion because the credit
spreads on some of its long-term debt had narrowed. What happened was that
as the investment bank grew more reliable to its creditors over the first
part of the year, its debt became more valuable. And under the dictates of
mark-to-mark accounting, the firm had to take a writeoff because of this
very positive occurrence.

Sound nuts? It has sounded so to many observers. In
the 15th paragraph of 157 FASB says, nevertheless, that "the fair value of
[a company's] liability shall reflect the nonperformance risk relating to
that liability." Thus, as the nonperformance risk--as reflected by slimmer
credit spreads—narrowed, Morgan Stanley had to reflect the decreased value
of its debt as a decrease in sales on its income statement.

Like the alleged evils of mark-to-market accounting
in illiquid markets—although to a lesser extent—the irrational practice of
forcing improved creditworthiness to be reflected in revenue decreases has
become fodder for fair value’s enemies. When FASB made its recent amendments
to 157, it neglected to attack the provision. If only to preserve fair-value
accounting from more political attacks, it should do so now.

We need
honest accounting more than ever, not fantasy teases for investors

This is a
pretty good article on how players (banks), umpires (regulators), and fans (like
billionnaires Stever Forbes and Warren Buffet) have inappropriately blamed the
scorekeepers (accounts) for the demise of the big banks. In fact the December
30, 2008 research report calls this attribution of blame just plain wrong (and
self-serving).

The wonderful December 30, 2008 research report of the SEC shows that fair value
accounting is neither the cause nor the cure for the banking crisis. The
liquidity problem of the holders of the toxic investments is caused by trillions
of dollars invested in underperforming (often zero performing) of bad
investments mortgages or mortgaged-backed bonds that have to be written down
unless auditors agree to simply lie about values. That is not likely to happen,
but client pressures on auditors to value on the high side for many properties
will be heavy handed.
The wonderful full SEC report that bankers and regulators do not want to read
can be freely downloaded at
http://www.sec.gov/news/studies/2008/marktomarket123008.pdf

Mark-to-market (MTM) accounting is under fierce attack by bank CEOs and
others who are pressing Congress to suspend, if not repeal, the rules they
blame for the current financial crisis. Yet their pleas to bubble-wrap
financial statements run counter to increased calls for greater
financial-market transparency and ongoing efforts to restore investor trust.

We have a sorry history of the banking industry driving statutory and
regulatory changes. Now banks want accounting fixes to mask their
recklessness. Meanwhile, there has been no acknowledgment of culpability in
what top management in these financial institutions did -- despite warnings
-- to help bring about the crisis. Theirs is a record of lax risk
management, flawed models, reckless lending, and excessively leveraged
investment strategies. In the worst instances, they acted with moral
indifference, knowing that what they were doing was flawed, but still
willing to pocket the fees and accompanying bonuses.

MTM accounting isn't perfect, but it does provide a compass for investors to
figure out what an asset would be worth in today's market if it were sold in
an orderly fashion to a willing buyer. Before MTM took effect, the Financial
Accounting Standards Board (FASB) produced much evidence to show that
valuing financial instruments and other difficult-to-price assets by
"historical" costs, or "mark to management," was folly.

The rules now under attack are neither as significant nor as inflexible as
critics charge. MTM is generally limited to investments held for trading
purposes, and to certain derivatives. For many financial institutions, these
investments represent a minority of their total investment portfolio. A
recent study by Bloomberg columnist David Reilly of the 12 largest banks in
the KBW Bank Index shows that only 29% of the $8.46 trillion in assets are
at MTM prices. In General Electric's case, the portion is just 2%.

Why is that so? Most bank assets are in loans, which are held at their
original cost using amortization rules, minus a reserve that banks must set
aside as a safety cushion for potential future losses.

MTM rules also give banks a choice. MTM accounting is not required for
securities held to maturity, but you need to demonstrate a "positive intent
and ability" that you will do so. Further, an SEC 2008 report found that
"over 90% of investments marked-to-market are valued based on observable
inputs."

Financial institutions had no problem in using MTM to benefit from the drop
in prices of their own notes and bonds, since the rule also applies to
liabilities. And when the value of the securitized loans they held was
soaring, they eagerly embraced MTM. Once committed to that accounting
discipline, though, they were obligated to continue doing so for the
duration of their holding of securities they've marked to market. And one
wonders if they are as equally willing to forego MTM for valuing the same
illiquid securities in client accounts for margin loans as they are for
their proprietary trading accounts?

But these facts haven't stopped the charge forward on Capitol Hill. At a
recent hearing, bankers said that MTM forced them to price securities well
below their real valuation, making it difficult to purge toxic assets from
their books at anything but fire-sale prices. They also justified their
attack with claims that loans, mortgages and other securities are now safe
or close to safe, ignoring mounting evidence that losses are growing across
a greater swath of credit. This makes the timing of the anti-MTM lobbying
appear even more suspect. And not all financial firms are calling for
loosening MTM standards; Goldman Sachs and others who are standing firm on
this issue should be applauded.

According to J.P. Morgan, approximately $450 billion of collateralized debt
obligations (CDOs) of asset-backed securities were issued from late 2005 to
mid-2007. Of that amount, roughly $305 billion is now in a formal state of
default and $102 billion of this amount has already been liquidated. The
latest monthly mortgage reports from investment banks are equally sobering.
It is no surprise, then, that the largest underwriters of mortgages and CDOs
have been decimated.

Commercial banking regulations generally do not require banks to sell assets
to meet capital requirements just because market values decline. But if
"impairment" charges under MTM do push banks below regulatory capital
requirements and limit their ability to lend when they can't raise more
capital, then the solution is to grant temporary regulatory capital
"relief," which is itself an arbitrary number.

There is a connection between efforts over the past 12 years to reduce
regulatory oversight, weaken capital requirements, and silence the financial
detectives who uncovered such scandals as Lehman and Enron. The assault
against MTM is just the latest chapter.

Instead of acknowledging mistakes, we are told this is a "once in 100 years"
anomaly with the market not functioning correctly. It isn't lost on
investors that the MTM criticisms come, too, as private equity firms must
now report the value of their investments. The truth is the market is
functioning correctly. It's just that MTM critics don't like the prices that
investors are willing to pay.

The FASB and Securities and Exchange Commission (SEC) must stand firm in
their respective efforts to ensure that investors get a true sense of the
losses facing banks and investment firms. To be sure, we should work to make
MTM accounting more precise, following, for example, the counsel of the
President's Working Group on Financial Markets and the SEC's December 2008
recommendations for achieving greater clarity in valuation approaches.

Unfortunately, the FASB proposal on March 16 represents capitulation. It
calls for "significant judgment" by banks in determining if a market or an
asset is "inactive" and if a transaction is "distressed." This would give
banks more discretion to throw out "quotes" and use valuation alternatives,
including cash-flow estimates, to determine value in illiquid markets. In
other words, it allows banks to substitute their own wishful-thinking
judgments of value for market prices.

The FASB is also changing the criteria used to determine impairment, giving
companies more flexibility to not recognize impairments if they don't have
"the intent to sell." Banks will only need to state that they are more
likely than not to be able to hold onto an underwater asset until its price
"recovers." CFOs will also have a choice to divide impairments into "credit
losses" and "other losses," which means fewer of these charges will be
counted against income. If approved, companies could start this quarter to
report net income that ignores sharp declines in securities they own. The
FASB is taking comments until April 1, but its vote is a fait accompli.

Obfuscating sound accounting rules by gutting MTM rules will only further
reduce investors' trust in the financial statements of all companies,
causing private capital -- desperately needed in securities markets -- to
become even scarcer. Worse, obfuscation will further erode confidence in the
American economy, with dire consequences for the very financial institutions
who are calling for MTM changes. If need be, temporarily relax the arbitrary
levels of regulatory capital, rather than compromise the integrity of all
financial statements.

If any of you are interested in listening to the
media conference given by Paul Cherry, Chair of Canadian Accounting Standard
Board, you can access an audio file through the link below. The story was
picked up by the National Post, the Globe and Mail, Reuters, Bloomberg,
Canadian Press and a number of small online news outlets and blogs.

Looking
for blue sky above polluted bank accounting hot air
Bank Profits Appear Out of Thin Air in 2009

Question
What direction did the price of shares of Bank of America move when BofA
announced higher than expected earnings for the first quarter of 2009?
Answer
Down, because investors suspect that such earnings were not sustainable while
BofA holds billions of dollars of Countrywide and Merrill Lynch toxic paper that
will drive down future earnings due to non-performance of home owners and
business owners who will not fully perform on loans.

The magic
accounting tricks in 2009 are hurting rather than helping to restore faith in
accounting and auditing after the 2008 banking crash.

Sydney Finkelstein, the Steven Roth professor of management at the Tuck School
of Business at Dartmouth College, also pointed out that Bank of America booked a
$2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired
last quarter to prices that were higher than Merrill kept them. “Although
perfectly legal, this move is also perfectly delusional, because some day soon
these assets will be written down to their fair value, and it won’t be pretty,”
he said
"Bank Profits Appear Out of Thin Air ," by Andrew Ross Sorkin, The New
York Times, April 20, 2009 ---
http://www.nytimes.com/2009/04/21/business/21sorkin.html?_r=1&dbk

This is starting to feel like amateur hour for aspiring magicians.

Another day, another attempt by a Wall Street bank to pull a bunny out of
the hat, showing off an earnings report that it hopes will elicit oohs and
aahs from the market. Goldman Sachs, JPMorgan Chase, Citigroup and, on
Monday, Bank of America all tried to wow their audiences with what appeared
to be — presto! — better-than-expected numbers.

But in each case, investors spotted the attempts at sleight of hand, and
didn’t buy it for a second.

With Goldman Sachs, the disappearing month of December didn’t quite
disappear (it changed its reporting calendar, effectively erasing the impact
of a $1.5 billion loss that month); JPMorgan Chase reported a dazzling
profit partly because the price of its bonds dropped (theoretically, they
could retire them and buy them back at a cheaper price; that’s sort of like
saying you’re richer because the value of your home has dropped); Citigroup
pulled the same trick.

Bank of America sold its shares in China Construction Bank to book a big
one-time profit, but Ken Lewis heralded the results as “a testament to the
value and breadth of the franchise.”

Sydney Finkelstein, the Steven Roth professor of management at the Tuck
School of Business at Dartmouth College, also pointed out that Bank of
America booked a $2.2 billion gain by increasing the value of Merrill
Lynch’s assets it acquired last quarter to prices that were higher than
Merrill kept them.

“Although perfectly legal, this move is also perfectly delusional, because
some day soon these assets will be written down to their fair value, and it
won’t be pretty,” he said.

Investors reacted by throwing tomatoes. Bank of America’s stock plunged 24
percent, as did other bank stocks. They’ve had enough.

Why can’t anybody read the room here? After all the financial wizardry that
got the country — actually, the world — into trouble, why don’t these
bankers give their audience what it seems to crave? Perhaps a bit of simple
math that could fit on the back of an envelope, with no asterisks and no
fine print, might win cheers instead of jeers from the market.

What’s particularly puzzling is why the banks don’t just try to make some
money the old-fashioned way. After all, earning it, if you could call it
that, has never been easier with a business model sponsored by the federal
government. That’s the one in which Uncle Sam and we taxpayers are offering
the banks dirt-cheap money, which they can turn around and lend at much
higher rates.

“If the federal government let me borrow money at zero percent interest, and
then lend it out at 4 to 12 percent interest, even I could make a profit,”
said Professor Finkelstein of the Tuck School. “And if a college professor
can make money in banking in 2009, what should we expect from the highly
paid C.E.O.’s that populate corner offices?”

But maybe now the banks are simply following the lead of Washington, which
keeps trotting out the latest idea for shoring up the financial system.

The latest big idea is the so-called stress test that is being applied to
the banks, with results expected at the end of this month.

This is playing to a tough crowd that long ago decided to stop suspending
disbelief. If the stress test is done honestly, it is impossible to believe
that some banks won’t fail. If no bank fails, then what’s the value of the
stress test? To tell us everything is fine, when people know it’s not?

“I can’t think of a single, positive thing to say about the stress test
concept — the process by which it will be carried out, or outcome it will
produce, no matter what the outcome is,” Thomas K. Brown, an analyst at
Bankstocks.com, wrote. “Nothing good can come of this and, under certain,
non-far-fetched scenarios, it might end up making the banking system’s
problems worse.”

The results of the stress test could lead to calls for capital for some of
the banks. Citi is mentioned most often as a candidate for more help, but
there could be others.

The expectation, before Monday at least, was that the government would pump
new money into the banks that needed it most.

But that was before the government reached into its bag of tricks again. Now
Treasury, instead of putting up new money, is considering swapping its
preferred shares in these banks for common shares.

The benefit to the bank is that it will have more capital to meet its ratio
requirements, and therefore won’t have to pay a 5 percent dividend to the
government. In the case of Citi, that would save the bank hundreds of
millions of dollars a year.

And — ta da! — it will miraculously stretch taxpayer dollars without
spending a penny more.

The Financial Accounting Standards Board, pressured by U.S. lawmakers and
financial companies, voted to relax fair-value rules that Citigroup Inc. and
Wells Fargo & Co. say don’t work when markets are inactive.

The changes to so-called mark-to-market accounting allow companies to use
“significant” judgment when gauging the price of some investments on their
books, including mortgage-backed securities. Analysts say the measure may
reduce banks’ writedowns and boost their first-quarter net income by 20
percent or more. FASB voted 3-2 to approve the rules at a meeting today in
Norwalk, Connecticut.

“Congress clearly indicated that some easing was probably appropriate in
this instance,” House Democratic Leader Steny Hoyer of Maryland said today
in a Bloomberg Television interview.

House Financial Services Committee members pressed FASB Chairman Robert Herz
at a March 12 hearing to revise fair-value, which requires banks to mark
assets each quarter to reflect market prices, saying the rule unfairly
punished financial companies. FASB’s proposals, made four days later,
spurred criticism from investor advocates and accounting-industry groups,
which say fair-value forces companies to disclose their true financial
health.

Blackstone Group LP Chairman Stephen Schwarzman, the American Bankers
Association and 65 lawmakers in the House of Representatives last September
urged that fair-value accounting, mandated by FASB, be suspended. William
Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985,
has called fair value “extremely and needlessly destructive” and “a major
cause” of the credit crisis. Robert Rubin, the former Citigroup senior
counselor and Treasury secretary, said Jan. 27 the rule has done “a great
deal of damage.”

“Good decision,” Citigroup Chairman Richard Parsons said of FASB’s move. The
market for mortgages and other assets was not working, so something had to
change, Parsons said in a New York interview today.

Banks rely on competitors’ asset sales to help determine the fair-market
value of similar securities they hold on their own books. FASB’s staff
conceded their March 17 proposal led to a “presumption” that all security
sales are “distressed” unless evidence proves otherwise. Such an
interpretation may have allowed financial companies to ignore transactions
in valuing their assets.

‘Orderly’ Transactions

FASB staff said banks should only disregard transactions that aren’t
“orderly,” including situations in which the “seller is near bankruptcy” or
needed to sell the asset to comply with regulatory requirements. Responding
to criticism from investor and accounting groups, the staff said in a report
today it was not FASB’s intent “to change the objective of a fair-value
measurement.”

Fair-value “provides the kind of transparency essential to restoring public
confidence in U.S. markets,” former Securities and Exchange Commission
Chairman Arthur Levitt said in an interview yesterday.

Levitt is co-chairman, along with former SEC head William Donaldson, of the
Investors’ Working Group, a non-partisan panel formed to recommend
improvements to regulation of U.S. financial markets. Other members of the
group, which met in New York yesterday, include Brooksley Born, former
chairman of the Commodity Futures Trading Commission, and Bill Miller, chief
investment officer of Legg Mason Capital Management Inc.

‘Deeply Concerned’

“The group is deeply concerned about the apparent FASB succumbing to
political pressures, which prevent U.S. investors from understanding the
true obligations of U.S. financial institutions,” Levitt said. Levitt is a
senior adviser at buyout firm Carlyle Group and a board member at Bloomberg
LP, the parent of Bloomberg News.

Fair-value requires companies to set values on most securities each quarter
based on market prices. Wells Fargo and other banks argue the rule doesn’t
make sense when trading has dried up because it forces companies to write
down assets to fire-sale prices.

By letting banks use internal models instead of market prices and allowing
them to take into account the cash flow of securities, FASB’s changes could
raise bank industry earnings by 20 percent, according to Robert Willens, a
former managing director at Lehman Brothers Holdings Inc. who runs his own
tax and accounting advisory firm in New York.

Companies weighed down by mortgage-backed securities, such as New York-based
Citigroup, could cut their losses by 50 percent to 70 percent, said Richard
Dietrich, an accounting professor at Ohio State University in Columbus.

FASB rejected requests from banks to let them apply the fair-value change to
their year-end financial statements for 2008. While the new standard takes
effect for earnings reports filed at the end of June, FASB said companies
could apply it to their first-quarter financial statements.

Finally, the FASB held its long-anticipated meeting on the two FSPs that
would have gutted fair value reporting as it exists. There's been more
hoopla (and hope-la) about these two amendments than in all of March
Madness.

Briefly, here's what transpired, as best as I could tell from the webcast of
the meeting:

1. FSP 157-e, the proposal which would have provided a direct route
to Level 3 modeling of fair values whenever there was a problem with quoted
prices, will be quite different from the original plan. There will be
indicators of inactive markets in the final FSP, but they'll only be
indicators for a preparer to consider - and more importantly, their presence
WILL NOT create a presumption of a distressed price for securities in
question. That part of the proposal would have greased the skids for Level 3
modeling. Not now.

There will be added required disclosures, which were not in the exposure
draft. One that I caught: quarterly "aging" disclosures of the securities
that are in a continuous loss position for more than 12 months and less than
12 months. As discussed in last week's report on the proposals, these
now-annual disclosures are useful for assessing riskiness of assets that
could become a firm's next other-than-temporary impairment charge.

Bottom line: investors didn't lose here.

2. FSP FAS 115-a, 124-a, and EITF 99-20-b, the proposal that softens
the blow of recognizing other-than-temporary impairments, was essentially
unchanged from the original proposal. It remains a chancre on the body of
accounting literature. The credit portion of an other-than-impairment loss
will be recognized in earnings, with all other attributed loss being
recorded in "other comprehensive income," to be amortized into earnings over
the life of the associated security. That's assuming the
other-than-temporary impairment is recognized at all, because the
determination will still be largely driven by the intent of the reporting
entity and whether it's more likely than not that it will have to sell the
security before recovery. This is a huge mulligan for banks with junky
securities.

If OTT charges are taken, the full amount of the impairment will be
disclosed on the income statement with the amount being shunted into other
comprehensive income shown as a reduction of the loss, leaving only the
credit portion to be recognized in current period earnings.

Bottom line: Investors lost on this vote, and they will have to pay
more attention to OCI in the future, as it becomes a more frequently-used
receptacle for unwanted debits. When investors note these "detoured charges"
in earnings, they should skip the detour and factor the full charge into
their evaluation of earnings. A small victory for investors: the original
proposal would have included other-than-temporary impairments on equity
securities. The final decision will affect only debt securities.

There was a third, much less-heralded FSP voted upon at the meeting:

3. FSP FAS 107-a and APB 28-a, which will make the now-annual fair
value disclosures for all financial instruments required on a quarterly
basis. This will be required beginning in the second quarter, with early
implementation allowed in the first quarter.

All three FSPs will become effective in the second quarter, with early
implementation allowed in the first quarter. Note: any firm electing early
adoption of the impairment FSP cannot wait until later to adopt the FSP
157-e fair value amendment. If they change the way they recognize
impairments, they also have to change how they consider the calculation of
fair values.

Some board members expressed hope that this was the last of the "emergency
amendments" to take place at the end of a reporting period. It seems too
much to hope for; there could more ahead, depending on how meddlesome the
G-20 would like to be. Remember when IFRS in the United States was a hot
topic? To a very large degree, that sprouted from a trans-Atlantic summit
meeting between the EU and the White House. The same thing could happen
again if the G-20 gang decides they know accounting better than the
standard-setters.

Jensen
Comment
It’s another one of those 3-2 FASB votes that gets Tom Selling hot under the
collar. Guess which Board members voted yes?

I’m less
critical of the so-called “easing of fair value rules” because I always thought
it was possible to estimate cash flows and build a model under Level 3 of FAS
157. To me this is all smoke and mirrors that lend added justification for banks
to underestimate their bad debt reserves. When the lawsuits roll in there will
be more authoritative support for inflating income of banks --- that’s what its all about isn’t it?

Banks need
to attract more investors to their manure piles. It’s a whole new springtime for
maggots to pursue outrageous leveraging.

The best
illustration of the smoke and mirrors part comes from the incomprehensible FASB
audio mp3 file on April 2. Try to get your best students to make any sense out
of that magic lantern show!

Questions
Did the FASB's amended fair value guidelines give the players (banks), umpires
(regulators), and fans (notably shareholders like Steve Forbes and Warren
Buffett seeking a new stock market bubble) the overvalued wine they were
seeking? Will the new guidelines mostly increase client pressures on auditors to
sign off on fantasy financial statements?

Although the new FASB Guidelines for estimating fair value under FAS 157 and FAS
115 in "broken markets" expands client/auditor discretion for some types of
assets having long-term value such as real estate, it's asking a lot to have
auditors agree once again to rosy valuation of sorry-looking toxic investments
such as the value of a mortgage that's about to wither on the vine. You can't
squeeze sweet grape juice from shriveled homeowners, let alone fine wine. It
may, however, be that higher value on foreclosed properties in bank inventories
will lead to some partying over banks' financial statements.

The
wonderful December 30, 2008 research report of the SEC shows that fair value
accounting is neither the cause nor the cure for the banking crisis. The
liquidity problem of the holders of the toxic investments is caused by trillions
of dollars invested in underperforming (often zero performing) of bad
investments mortgages or mortgaged-backed bonds that have to be written down
unless auditors agree to simply lie about values. That is not likely to happen,
but client pressures on auditors to value on the high side for many properties
will be heavy handed.
The wonderful full SEC report that bankers and regulators do not want to read
can be freely downloaded at
http://www.sec.gov/news/studies/2008/marktomarket123008.pdf

Following a hearing at a House Financial Services subcommittee last week,
the Financial Accounting Standards Board (FASB) agreed to expedite release
of their proposed guidance for the application of FAS 157 "Fair Value
Measurement." The proposed guidance was published for public comment on
March 17th and will be voted on by the Board on April 2. If approved, the
FASB recommends that the guidance be effective for interim and annual
periods ending after March 15, 2009. According to CFO.com, FASB chairman,
Robert H. Herz, chairman of the Financial Accounting Standards Board (FASB),
told legislators, "We can have the guidance in three weeks, but whether that
will fix everything is another [issue]."

SB's proposal give more detailed guidance for valuing assets that would be
classified as Level 3 under FAS 157, where values are assigned in the
absence of an active market or where a sale has occurred in distressed
circumstances when prices are temporarily weighed down. The new guidance
allows companies to use their own models and estimates and exercise
"significant judgment" to determine whether a market exists or whether the
input is from a distressed sale. Under FAS 157, financial instruments' fair
values cannot be based on distressed sales.

FASB had planned to issue the proposed guidance by the end of the second
quarter. A study on mark-to-market accounting standards conducted by the
Securities and Exchange Commission (SEC), which was mandated by the
Emergency Economic Stabilization Act of 2008, concluded that more
application guidance to determine fair values was needed in current market
conditions. On February 18, Herz announced that FASB agreed with the SEC
study and would develop additional guidance.

Thomas Linsmeier, FASB board member, said that they hoped that the new
guidance could lead to more accurate and possibly higher values, CFO.com
reports. "What we are voting on will hopefully elevate fair values to a more
reasonable price so investors are more comfortable investing in the banking
system," he said.

Edward Yingling, president of the American Bankers Association, said in a
statement he welcomed the proposal but expressed caution about the ways it
might be used by auditors, MarketWatch says. "While we welcome today's news,
it will be important to look at the details of the written proposal to see
how fully it improves the guidance. It will also be imperative to examine
the practical effect the proposal will have based on the various ways it is
interpreted."

The FASB proposal recommends that companies take two steps to determine
whether there an active market exists and whether a recent sale is
distressed before applying their own models and judgment:

Step 1:
Determine whether there are factors present that indicate that the market
for the asset is not active at the measurement date. Factors include:

·
Few recent transactions (based on volume and level of activity in the
market). Thus, there is not sufficient frequency and volume to provide
pricing information on an ongoing basis.

·
Price quotations are not based on current information.

·
Price quotations vary substantially either over time or among market makers
(for example, some brokered markets).

·
Indices that previously were highly correlated with the fair values of the
asset are demonstrably uncorrelated with recent fair values.

·
Abnormal (or significant increases in) liquidity risk premiums or implied
yields for quoted prices when compared to reasonable estimates of credit and
other nonperformance risk for the asset class.

If after evaluating all the factors the sum of the evidence indicates that
the market is not active, the reporting entity shall apply step 2.

Step 2:
Evaluate the quoted price (that is, a recent transaction or broker price
quotation) to determine whether the quoted price is not associated with a
distressed transaction. The reporting entity shall presume that the quoted
price is associated with a distressed transaction unless the reporting
entity has evidence that indicates that both of the following factors are
present for a given quoted price:

·
There was a period prior to the measurement date to allow for marketing
activities that are usual and customary for transactions involving such
assets or liabilities (for example, there was not a regulatory requirement
to sell).

·
There were multiple bidders for the asset.

The proposed guidance also provides examples of measurement approaches in
the event that the observable input is from a distressed sale.

At Monday's meeting, Herz deflated any beliefs that FASB's new guidance will
be a panacea for the many ills of the U.S. economy. "There's not much
accounting can do other than help people get the facts and use their best
judgment," he said.

The International Accounting Standards Board, which sets accounting rules
followed by more than 100 countries, plans to publish a draft rule to
replace and simplify fair-value accounting rules. Critics say the rules have
exacerbated the credit crunch by forcing write-downs. "We plan to replace
it, the whole thing. We want to stop patching up the standard and we want to
write a new one. We are aware that the current model is too complex. We need
to simplify.... We will move to exposure draft hopefully within the next six
months," said Philippe Danjou, a member of the IASB board.

Finally, the FASB held its long-anticipated meeting on the two FSPs that
would have gutted fair value reporting as it exists. There's been more
hoopla (and hope-la) about these two amendments than in all of March
Madness.

Briefly, here's what transpired, as best as I could tell from the webcast of
the meeting:

1. FSP 157-e, the proposal which would have provided a direct route
to Level 3 modeling of fair values whenever there was a problem with quoted
prices, will be quite different from the original plan. There will be
indicators of inactive markets in the final FSP, but they'll only be
indicators for a preparer to consider - and more importantly, their presence
WILL NOT create a presumption of a distressed price for securities in
question. That part of the proposal would have greased the skids for Level 3
modeling. Not now.

There will be added required disclosures, which were not in the exposure
draft. One that I caught: quarterly "aging" disclosures of the securities
that are in a continuous loss position for more than 12 months and less than
12 months. As discussed in last week's report on the proposals, these
now-annual disclosures are useful for assessing riskiness of assets that
could become a firm's next other-than-temporary impairment charge.

Bottom line: investors didn't lose here.

2. FSP FAS 115-a, 124-a, and EITF 99-20-b, the proposal that softens
the blow of recognizing other-than-temporary impairments, was essentially
unchanged from the original proposal. It remains a chancre on the body of
accounting literature. The credit portion of an other-than-impairment loss
will be recognized in earnings, with all other attributed loss being
recorded in "other comprehensive income," to be amortized into earnings over
the life of the associated security. That's assuming the
other-than-temporary impairment is recognized at all, because the
determination will still be largely driven by the intent of the reporting
entity and whether it's more likely than not that it will have to sell the
security before recovery. This is a huge mulligan for banks with junky
securities.

If OTT charges are taken, the full amount of the impairment will be
disclosed on the income statement with the amount being shunted into other
comprehensive income shown as a reduction of the loss, leaving only the
credit portion to be recognized in current period earnings.

Bottom line: Investors lost on this vote, and they will have to pay
more attention to OCI in the future, as it becomes a more frequently-used
receptacle for unwanted debits. When investors note these "detoured charges"
in earnings, they should skip the detour and factor the full charge into
their evaluation of earnings. A small victory for investors: the original
proposal would have included other-than-temporary impairments on equity
securities. The final decision will affect only debt securities.

There was a third, much less-heralded FSP voted upon at the meeting:

3. FSP FAS 107-a and APB 28-a, which will make the now-annual fair
value disclosures for all financial instruments required on a quarterly
basis. This will be required beginning in the second quarter, with early
implementation allowed in the first quarter.

All three FSPs will become effective in the second quarter, with early
implementation allowed in the first quarter. Note: any firm electing early
adoption of the impairment FSP cannot wait until later to adopt the FSP
157-e fair value amendment. If they change the way they recognize
impairments, they also have to change how they consider the calculation of
fair values.

Some board members expressed hope that this was the last of the "emergency
amendments" to take place at the end of a reporting period. It seems too
much to hope for; there could more ahead, depending on how meddlesome the
G-20 would like to be. Remember when IFRS in the United States was a hot
topic? To a very large degree, that sprouted from a trans-Atlantic summit
meeting between the EU and the White House. The same thing could happen
again if the G-20 gang decides they know accounting better than the
standard-setters.

Exactly three weeks after FASB Chairman Robert Herz’s March 12 testimony
before a rancorous House Financial Services subcommittee, the independent
standard-setting board voted Thursday to release three new pieces of
guidance to address concerns over the application of fair value accounting
standards in current market conditions.

All three new pronouncements will be published in the form of FASB Staff
Positions (FSPs). FASB Technical Director Russell Golden said in a press
conference following the meeting that the final FSPs would not be available
until next week.

FASB Staff Position no. FAS 157-e, Determining Whether a Market Is Not
Active and a Transaction Is Not Distressed, establishes a process to
determine whether a market is not active and a transaction is not
distressed. The FSP says companies should look at several factors and use
judgment to ascertain if a formerly active market has become inactive. Once
a market is determined to be inactive, more work will be required. The
company must see if observed prices or broker quotes obtained represent
“distressed transactions.” Other techniques such as a discounted cash flow
analysis might also be appropriate in that circumstance, as long as it meets
the objective of estimating the orderly selling price of the asset in the
current market.

The AICPA’s Accounting Standards Executive Committee (AcSEC) submitted a
comment letter to FASB recommending against adoption of FSP FAS 157-e based
on concerns that it could be interpreted in a way that would contradict the
exit price model of FASB Statement no. 157, Fair Value Measurements.

But following the meeting, AcSEC Chairman Jay Hanson said he was pleased
that FASB clarified during its deliberations on Thursday that the FSP is not
intended to change the measurement objective of Statement no. 157.

The second FASB document—FSP FAS 115-a, FAS 124-a, and EITF 99-20-b,
Recognition and Presentation of Other-Than-Temporary Impairments—deals with
other-than-temporary impairment (OTTI). This FSP was passed by a 3-2 vote.
Under the new rules, once an OTTI is determined for a debt security, the
portion of an asset write down attributed to credit losses may flow through
earnings and the remaining portion may flow through other comprehensive
income, depending on the situation and facts involved. There will be several
new required disclosures about how the charges are split.

Initial reaction from financial institutions regarding the new OTTI rules
was positive. “I am pleased to see the changes being made and believe they
will provide more accurate financial information,” said Security Financial
Bank CFO Mark C. Oldenberg, CPA. “I expect there will be substantial
discussion on how to determine ‘credit losses’ versus ‘market losses’ and
whether to allow recovery of OTTI losses.”

But at least some investors did not appear to be quite so enthusiastic. “The
new guidance seems to be a result of government pressure,” said Jason S.
Inman, CPA, of McDonnell Investment Management LLC. “The fair value concept
before the change allowed for greater transparency in the market and for an
investor to make a decision as to whether or not the company had the ability
to hold those assets until recovery.”

“Investors lost on this vote,” wrote former FASB Emerging Issues Task Force
member Jack Ciesielski, CPA, on the AAO Weblog regarding the new OTTI rules.
“And they will have to pay more attention to other comprehensive income in
the future, as it becomes a more frequently-used receptacle for unwanted
debits. When investors note these ‘detoured charges’ in earnings, they
should skip the detour and factor the full charge into their evaluation of
earnings.”

The third piece of guidance—FSP FAS 107-B and APB 28-A, Interim Disclosures
About Fair Value of Financial Instruments—will increase the frequency from
annually to quarterly of disclosures providing qualitative and quantitative
information about fair value estimates for all those financial instruments
not measured on the balance sheet at fair value.

All three FSPs will be effective for periods ending after June 15, 2009.
Early adoption is permitted for periods ending after March 15, 2009.
However, if a company wants to adopt the FSP FAS 115-a, FAS 124-a, and EITF
99-20-b in the first quarter, it must also adopt the FSP FAS 157-e at the
same time.

April 3
message from Bob Jensen

Hi David,

I think I
can correctly surmise what IASB Board members who eventually dissent on easing
fair value accounting rules, and I think I it will be for the same reasons why
two of five FASB Board members voted against the FASB fair value changes
announced at
http://www.fasb.org/action/sbd040209.shtml

Is there a
pattern here in FASB voting on Fair Value Accounting? Maybe not if we accept the
rationale give to us by Denny Beresford. My own opinion is that this is not
really a fundamental change in FAS 157 since Level 3 always allowed valuation
based on models. What has changed is that clients and auditors will no longer be
so hesitant to move down to Level 3 after this official re-affirmation of Level
3 taken by the FASB on April 2 ---
http://seekingalpha.com/article/129189-fasb-s-fsp-decisions-bigger-than-basketball

There are
three United States IASB Board Members Mary Barth, John Smith, and Jim
Leisenring. My guess is that two of the three (maybe all three) will strongly
dissent if the IASB follows the April 2 lead on easing fair value accounting
rules set by the FASB on April 2.

Mary Barth
and John Smith strongly dissented when the IASB voted to allow entities a free
choice between the partial and full fair value alternatives to goodwill and NCI
measurement. Jim Leisingring went along with the majority of the IASB on that
issue, but I think he has stronger feelings about easing fair value accounting
rules. I don’t anticipate strong objections from the majority of the IASB voting
members.

If I’m correct the dissent is a straw man if you buy into the Level 3 of the
original FAS 157. However, it is a real tiger now that banks will once again be
underestimating bad debt reserves and overstating income with less worry about
investor class action lawsuits. This so-called change in accounting rules
certainly is consistent with “principled-based” accounting standards and will
lead to inconsistencies on how virtually identical financial instruments are
accounted for in practice.

One of the IASB board members is on my campus today and he fully expects the
IASB to follow the FASB's lead, which he strongly disagrees with. For the
record, I think the FASB's action was much needed clarification of the intent of
SFAS 157 and I applaud its efforts. This was not at all a situation of "bowing
to pressure" but rather one of realizing that earlier guidance hadn't been
applied in the intended manner. The FASB clearly accelerated its work in
response to Congressional concerns but moving too slowly has been a fault of the
FASB from the beginning, including the 10 1/2 years I was there.

April 2, 2009 is a day of accounting infamy. It is a day in which the
Financial Accounting Standards Board (FASB) bowed to the pressures of the
banking community and Congress to allow distortions, massagings, and
manipulations of the U.S. financial reports. Because of these cowardly acts,
I think it time for Robert Herz to resign from the FASB.

Robert Herz is the chairman of the FASB, appointed on July 1, 2002 and
reappointed on July 1, 2007. Before this he was a senior partner with
PricewaterhouseCoopers. I have read many of his papers and I have heard some
of his speeches. I have found Mr. Herz quite intelligent, filled with much
knowledge about accounting and finance, well-mannered, articulate, and an
avid defender of the accounting profession.

Unfortunately, I also find Herz lacking in courage and moral fortitude.
Whenever some bully comes on the scene and challenges him and the FASB to a
fight, he runs away. When accounting truth is at stake, he compromises and
enables corporate managers to use methods and vehicles by which they can
cook the books. Shame!

The first thing the FASB did at its April 2 meeting concerns whether a
market is not active and a transaction is not distressed. In this FSP FAS
157-e, the board allows business enterprises to weigh the evidence whether
the a transaction involved an orderly market; in reality it will permit
managers to ignore distressed conditions, some of which they themselves
created, and to pretend some “value” based on normalcy. Clearly, this will
buoy asset prices on the balance sheet and reduce losses or create gains on
the income statement. Too bad this is fiction.

In the second matter the FASB addressed other-than-temporary impairments. In
this FSP the FASB permits managers to overlook other-than-temporary
impairments if management believes that it does not have the intent to sell
the security and it is more likely than not it will not have to sell the
security before recovery of its cost basis. Of course, that will be just
about everybody so this is a vacuous recognition condition.

The FSP goes on to state that gains or losses due to credit risk will go
into the income statement, while noncredit gains and losses will bypass the
income statement and go directly into comprehensive income. This distinction
appears academic as in practice it is hard to distinguish credit losses from
noncredit losses. Clearly, this decision will give managers ample room to
manipulate the income statement.

The FASB got pushed into this decision and Robert Herz caved in. This isn’t
the first time either. Herz became chairman after Enron’s special purpose
entities exploded on Wall Street and has yet to do anything about them.
These special purpose entities have also played a part in the current
banking crisis. Herz also presided over the new rules on business
combinations. While I applaud the elimination of the pooling option, which
enabled many corporate frauds, I remain skeptical of the treatment of
goodwill, which is another loophole. And Robert Herz keeps preaching against
complexity and for simplicity and principles-based accounting, which are
keywords to allow corporate executives the power to do as they wish with the
recognition and measurement of revenues and other elements. (Bob, if these
FSPs are based on any legitimate principles, pray tell us which ones.)

Writing about these items when originally proposed,
Jonathan Weil referred to the FASB as the Fraudulent Accounting Standards
Board.
I am sympathetic with his f-word, but I think it may be too harsh. After
all, the board is “merely” allowing managers to commit fraud without facing
any disincentives. But I think there are other f-words that we could employ,
such as fearful, feckless, and futile.

Mr. Herz, please resign. You are making the board ineffective as a standard
bearer for accounting truth. While I think you have a sense of right and
wrong, you are not willing to hold bankers accountable for their mistakes
and you are not willing to stand up against politicians who favor lies.

This
essay reflects the opinion of the author and not necessarily the opinion of
The Pennsylvania State University.

The idea that massive changes have been made is a huge overstatement. FASB is
basically reiterating what it has said all along. A number of comments from both
bank insiders and analysts indicate that no material changes have been made, .
. . Estimates vary but it seems MTM changes won’t have as big an impact as some
would like to believe. Remember, as Jim Chanos pointed out, the vast majority of
bank assets such as ordinary loans, are NOT marked to market and that the
delinquencies on almost all classes of loans continue to rise. Thus relaxing
mark to market will not help stop the rising delinquencies across a wide swathe
of bank assets.
The idea that giving bank executives more leeway in how they price their assets
when a large part of the current problems is a lack of transparency is
laughable. "Latest on
Mark to Market Scapegoat," The Fundamental Analyst, on April 2, 2009 ---
http://www.thefundamentalanalyst.com/?p=1145

Jensen
Comment
Although I tend to agree that the FASB's April 2, 2009 change was not that much
of a change at all since Level 3 value estimates could come from subjective
estimates of future streams of cash flows. However, the problem will be that the
banks themselves use this re-enforce banks to depart from market on bad debt
reserves. Banks will accordingly understate bad debt reserves and overstate
earnings.

SUMMARY: Accounting
rule makers will vote Thursday on proposals to soften
"mark-to-market" accounting, the controversial rules requiring
companies to peg their investments' value to the market's ups and
downs. Many banks blame the rules for worsening their current
problems, by locking in losses that they say are merely temporary.

CLASSROOM APPLICATION: Financial
institutions continue to criticize the mark-to-market accounting
rules. This article reports on the proposal to soften those rules,
keeping our classes current on the issue. Additionally, this article
offers an opportunity to discuss an opinion piece, which takes the
slant that the criticism of these rules is "largely bogus." You
could use this article as an opportunity to discuss opinion pieces
versus articles that report only news with no commentary, as well as
ask the students their opinions on whether they agree with the
writer.

QUESTIONS:
1. (Introductory)
What changes have been proposed regarding mark-to-market accounting?
What body votes on these proposals?

2. (Advanced)
Why is mark-to-market accounting such a big issue in the business
world? What claims do financial institutions make regarding
mark-to-market? What do mark-to-market supporters say?

3. (Advanced)
What are "available-for-sale" investments? What is the current
accounting treatment for these assets? Please explain the changes
under the proposal. How would the change affect financial reporting
and investors?

4. (Introductory)
What is the FASB? What concerns does the writer have regarding FASB
independence? Do you think those concerns are legitimate?

5. (Introductory)
What is the position of the writer in this article? How does this
article differ from news stories? Why do newspapers publish these
types of articles? Do you agree with the writer? Why or why not?

Three leading accountics (not a spelled wrong) professors (from MIT, Chicago, and
Wharton) question the costs versus benefits of the SEC's proposed changeover
from U.S. GAAP to international (IFRS) GAAP"Mind the GAAP: Analyzing the Proposed Switch to
International Accounting Standards," Knowledge@Wharton , April 1, 2009 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2192

But there
are some tough questions about the move that have yet to be
answered, according to Wharton accounting professor
Luzi Hail, who, with professors
Christian Leuz from the University of Chicago and Peter
Wysocki of MIT's Sloan School of Management, recently
conducted research on the potential impacts of the change.
They present their findings in a paper titled, "Global
Accounting Convergence and the Potential Adoption of IFRS by
the United States: An Analysis of Economic and Policy
Factors." In March, the FASB and
its parent, the Financial Accounting Foundation (FAF), sent
a 132-page letter to the Securities and Exchange Commission
reflecting many of the concerns raised in the research,
which received funding from the FASB but, according to Hail,
was conducted and reported independently.

The defining moments of our financial crisis are
now familiar. Last September, Lehman collapsed and AIG was teetering.
Because an AIG collapse was viewed as posing unacceptable systemic risks,
the Federal Reserve provided the company with an emergency $85 billion loan
on Sept. 16.

But a curious incident that fateful day raises
significant public policy issues. Goldman Sachs reported that its exposure
to AIG was "not material." Yet on March 15 of this year, AIG disclosed that
it paid $7 billion of its government loan last fall to satisfy obligations
to Goldman. A "not material" statement and a $7 billion payout appear to be
at odds.

Why didn't Goldman bark that September day? One
explanation is that Goldman was, to use a term that I coined a few years
ago, largely an "empty creditor" of AIG. More generally, the empty-creditor
phenomenon helps explain otherwise-puzzling creditor behavior toward
troubled debtors. Addressing the phenomenon can help us cope with its impact
on individual debtors and the overall financial system.

What is an empty creditor? Consider that debt
ownership conveys a package of economic rights (to receive principal and
interest), contractual control rights (to enforce the terms of the
agreement), and other legal rights (to participate in bankruptcy
proceedings). Traditionally, law and business practice assume these
components are bundled together. Another foundational assumption: Creditors
generally want to keep solvent firms out of bankruptcy and to maximize their
value.

These assumptions can no longer be relied on.
Credit default swaps and other products now permit a creditor to avoid any
actual exposure to financial risk from a shaky debt -- while still
maintaining his formal contractual control rights to enforce the terms of
the debt agreement, and his legal rights under bankruptcy and other laws.

Thus the "empty creditor": someone (or institution)
who may have the contractual control but, by simultaneously holding credit
default swaps, little or no economic exposure if the debt goes bad. Indeed,
if a creditor holds enough credit default swaps, he may simultaneously have
control rights and incentives to cause the debtor firm's value to fall. And
if bankruptcy occurs, the empty creditor may undermine proper
reorganization, especially if his interests (or non-interests) are not fully
disclosed to the bankruptcy court.

Goldman Sachs was apparently an empty creditor of
AIG. On March 20, David Viniar, Goldman's chief financial officer, indicated
that the company had bought credit default swaps from "large financial
institutions" that would pay off if AIG defaulted on its debt. A Bloomberg
News story on that day quotes Mr. Viniar as saying that "[n]et-net I would
think we had a gain over time" with respect to the credit default swap
contracts.

Goldman asserted its contractual rights to require
AIG to provide collateral on transactions between the two, notwithstanding
the impact of such collateral calls on AIG. This behavior was
understandable: Goldman had responsibilities to its own shareholders and, in
Mr. Viniar's words, was "fully protected and didn't have to take a loss."

Nothing in the law prevents any creditor from
decoupling his actual economic exposure from his debt. And I do not suggest
any inappropriate behavior on the part of Goldman or any other party from
such "debt decoupling." But none of the existing regulatory efforts
involving credit derivatives are directed at the empty-creditor issue. Empty
creditors have weaker incentives to cooperate with troubled corporations to
avoid collapse and, if collapse occurs, can cause substantive and disclosure
complexities in bankruptcy.

An initial, incremental, and low-cost step lies in
the area of a real-time informational clearinghouse for credit default swaps
and other over-the-counter (OTC) derivatives transactions and other crucial
derivatives-related information. Creditors are not generally required to
disclose the "emptiness" of their status, or how they achieved it. More
generally, OTC derivatives contracts are individually negotiated and not
required to be disclosed to any regulator, much less to the public
generally. No one regulator, nor the capital markets generally, know on a
real-time basis the entity-specific exposures, the ultimate resting places
of the credit, market, and other risks associated with OTC derivatives.

With such a clearinghouse, the interconnectedness
of market participants' exposures would have been clearer, governmental
decisions about bailing out Lehman and AIG would have been better informed,
and the market's disciplining forces could have played larger roles. Most
important, a clearinghouse could have helped financial institutions to avoid
misunderstanding their own products, and modeling and risk assessment
systems -- misunderstandings that contributed to the global economic crisis.

Overstock.com (NASDAQ: OSTK) and its management
team led by its CEO and masquerading stock market reformer Patrick Byrne
(pictured on right) continued its pattern of false and misleading
disclosures and departures from Generally Accepted Accounting Principles (GAAP)
in its latest Q1 2009 financial report.

In Q1 2009, Overstock.com reported a net loss of
$2.1 million compared to $4.7 million in Q1 2008 and claimed an earnings
improvement of $2.6 million. However, the company's reported $2.6 reduction
in net losses was aided by a violation of GAAP (described in more detail
below) that reduced losses by $1.9 million and buybacks of Senior Notes
issued in 2004 under false pretenses that reduced losses by another $1.9
million.

After the issuance of the Senior Notes in November
2004, Overstock.com has twice restated financial reports for Q1 2003 to Q3
2004 (the accounting periods immediately preceding the issuance of such
notes) because of reported accounting errors and material weaknesses in
internal controls.

While new CFO Steve Chestnut hyped that "It's been
a great Q1," the reality is that Overstock.com’s reported losses actually
widened by $1.2 million after considering violations of GAAP ($1.9 million)
and buying back notes issued under false pretenses ($1.9 million).

How Overstock.com improperly reported of an
accounting error and created a “cookie jar reserve” to manage future
earnings by improperly deferring recognition of an income

Before we begin, let’s review certain events
starting in January 2008.

In January 2008, the Securities and Exchange
Commission discovered that Overstock.com's revenue accounting failed to
comply with GAAP and SEC disclosure rules, from the company's inception.
This blog detailed how the company provided the SEC with a flawed and
misleading materiality analysis to convince them that its revenue accounting
error was not material. The company wanted to avoid a restatement of prior
affected financial reports arising from intentional revenue accounting
errors uncovered by the SEC.

Instead, the company used a one-time cumulative
adjustment in its Q4 2007 financial report, apparently to hide the material
impact of such errors on previous affected individual financial reports. In
Q4 2007, Overstock.com reduced revenues by $13.7 million and increased net
losses by $2.1 million resulting from the one-time cumulative adjustment to
correct its revenue accounting errors.

Q3 2008

On October 24, 2008, Overstock.com's Q3 2008 press
release disclosed new customer refund and credit errors and the company
warned investors that all previous financial reports issued from 2003 to Q2
2008 “should no longer be relied upon.” This time, Overstock.com restated
all financial reports dating back to 2003. In addition, Overstock.com
reversed its one-time cumulative adjustment in Q4 2007 used to correct its
revenue accounting errors and also restated all financial statements to
correct those errors, as I previously recommended.

The company reported that the combined amount of
revenue accounting errors and customer refund and credit accounting errors
resulted in a cumulative reduction in previously reported revenues of $12.9
million and an increase in accumulated losses of $10.3 million.

Q4 2008

On January 30, 2009, Overstock.com reported a $1
million profit and $.04 earnings per share for Q4 2008, after 15 consecutive
quarterly losses and it beat mean analysts’ consensus expectations of
negative $0.04 earnings per share. CEO Patrick Byrne gloated, "After a tough
three years, returning to GAAP profitability is a relief." However,
Overstock.com's press release failed to disclose that its $1 million
reported profit resulted from a one-time gain of $1.8 million relating to
payments received from fulfillment partners for amounts previously
underbilled them.

During the earnings call that followed the press
release, CFO Steve Chesnut finally revealed to investors that:

Gross profit dollars were $43.6 million, a 6%
decrease. This included a one-time gain of $1.8 million relating to payments
from partners who were under-billed earlier in the year.

Before Q3 2008, Overstock.com failed to bill its
fulfillment partners for offsetting cost reimbursements and fees resulting
from its customer refund and credit errors. After discovering foul up,
Overstock.com improperly corrected the billing
errors by recognizing income in future periods when such amounts were
recovered or on a cash basis (non-GAAP).

In a blog post, I explained why Statement of
Financial Accounting Standards No. 154 required Overstock.com to restate
affected prior period financial reports to reflect when the underbilled cost
reimbursements and fees were actually earned by the company (accrual basis
or GAAP). In other words, Overstock.com should have corrected prior
financial reports to accurately reflect when the income was earned from
fulfillment partners who were previously underbilled for cost reimbursements
and fees.

If Overstock.com properly followed accounting
rules, it would have reported an $800,000 loss instead of a $1 million
profit, it would have reported sixteen consecutive losses instead of 15
consecutive losses, and it would have failed to meet mean analysts’
consensus expectation for earnings per share (anyone of three materiality
yardsticks under SEC Staff Accounting Bulletin No. 99 that would have
triggered a restatement of prior year’s effected financial reports).

Patrick Byrne responds on a stock market chat board

In my next blog post, I described how CEO Patrick
M. Byrne tried to explain away Overstock.com’s treatment of the “one-time
gain” in an unsigned post, using an alias, on an internet stock market chat
board. Byrne’s chat board post was later removed and re-posted with his name
attached to it, after I complained to the SEC. Here is what Patrick Byrne
told readers on the chat board:

Antar's ramblings are gibberish. Show them to any
accountant and they will confirm. He has no clue what he is talking about.

For example: when one discovers that one underpaid
some suppliers $1 million and overpaid others $1 million. For those whom one
underpaid, one immediately recognizes a $1 million liability, and cleans it
up by paying. For those one overpaid, one does not immediately book an asset
of a $1 million receivable: instead, one books that as the monies flow in.
Simple conservatism demands this (If we went to book the asset the moment we
found it, how much should we book? The whole $1 million? An estimate of the
portion of it we think we'll be able to collect?) The result is asymmetric
treatment. Yet Antar is screaming his head off about this, while never once
addressing this simple principle. Of course, if we had booked the found
asset the moment we found it, he would have screamed his head off about
that. Behind everything this guy writes, there is a gross obfuscation like
this. His purpose is just to get as much noise out there as he can.

… Overstock.com recognized the "one-time of $1.8
million" using cash-basis accounting when it "received payments from
partners who were under-billed earlier in the year" instead of accrual basis
accounting, which requires income to be recognized when earned. A public
company is not permitted to correct any accounting error using cash-basis
accounting.

Overstock.com needed to justify Patrick Byrne’s
stock chat board ramblings. About two weeks later, Overstock.com filed its
fiscal year 2008 10-K report with the SEC and the company concocted a new
excuse to justify using cash basis accounting to correct its accounting
error and avoid restating prior affected financial reports:

In addition, during Q4 2008, we reduced Cost of
Goods Sold by $1.8 million for billing recoveries from partners who were
underbilled earlier in the year for certain fees and charges that they were
contractually obligated to pay. When the underbilling was originally
discovered, we determined that the recovery of such amounts was not assured,
and that consequently the potential recoveries constituted a gain
contingency. Accordingly, we determined that the appropriate accounting
treatment for the potential recoveries was to record their benefit only when
such amounts became realizable (i.e., an agreement had been reached with the
partner and the partner had the wherewithal to pay).

Note: Bold print and italics added by me.

Overstock.com improperly claimed that a "gain
contingency" existed by using the rationale that the collection of all "underbilled...fees
and charges...was not assured....”

Overstock.com already earned those "fees and
charges" and its fulfillment partners were "contractually obligated to pay"
such underbilled amounts. There was no question that Overstock.com was owed
money from its fulfillment partners and that such income was earned in prior
periods.

If there was any question as to the recovery of any
amounts owed the company, management should have made a reasonable estimate
of uncollectible amounts (loss contingency) and booked an appropriate
reserve against amounts due from fulfillment partners to reduce accrued
income (See SFAS No. 5 paragraph 1, 2, 8, 22, and 23). It didn’t. Instead,
Overstock.com claimed that the all amounts due the company from underbilling
its fulfillment partners was "not assured" and improperly called such
potential recoveries a "gain contingency" (SFAS No. 5 paragraph 1, 2, and
17).

The only way that Overstock.com could recognize
income from underbilling its fulfillment partners in future accounting
periods is if there was a “significant uncertainty as to collection” of all
underbilled amounts (See SFAS No. 5 paragraph 23)

As it turns out, a large portion of the underbilled
amounts to fulfillment partners was easily recoverable within a brief period
of time. In fact, within 68 days of announcing underbilling errors, the
company already collected a total of “$1.8 million relating to payments from
partners who were underbilled earlier in the year.” Therefore, Overstock.com
cannot claim that there was a "significant uncertainty as to collection" or
that recovery was "not assured."

No gain contingency existed. Overstock.com already
earned "fees and charges" from underbilled fulfillment partners in prior
periods. Rather, a loss contingency existed for a reasonably estimated
amount of uncollectible "fees and charges." Overstock.com should have
restated prior affected financial reports to properly reflect income earned
from fulfillment partners instead of reflecting such income when amounts
were collected in future quarters. Management should have made a reasonable
estimate for unrecoverable amounts and booked an appropriate reserve against
"fees and charges" owed to it (See SFAS No. 5 Paragraph 22 and 23).

Therefore, Overstock.com overstated its customer
refund and credit accounting error by failing to accrue fees and charges due
from its fulfillment partners as income in the appropriate accounting
periods, less a reasonable reserve for unrecoverable amounts. By deferring
recognition of income until underbilled amounts were collected, the company
effectively created a "cookie jar" reserve to increase future earnings.

In addition, Overstock.com failed to disclose any
potential “gain contingency” in its Q3 2008 10-Q report, when it disclosed
that it underbilled its fulfillment partners (See SFAS No. 5 Paragraph 17b).
Apparently, Overstock.com used a backdated rationale for using cash basis
accounting to correct its accounting error in response to my blog posts
(here and here) detailing its violation of GAAP.

PricewaterhouseCoopers warns against using
"conservatism to manage future earnings"

As I detailed above, Patrick Byrne claimed on an
internet chat board that “conservatism demands" waiting until "monies flow
in" from under-billed fulfillment partners to recognize income, after such
an error is discovered by the company. However, a document from
PricewaterhouseCoopers (Overstock.com’s auditors thru 2008) web site
cautions against using “conservatism” to manage future earnings by deferring
gains to future accounting periods:

"Conservatism...should no[t] connote deliberate,
consistent understatement of net assets and profits." Emphasis added] CON 5
describes realization in terms of recognition criteria for revenues and
gains, as:"Revenue and gains generally are not recognized until realized or
realizable... when products (goods or services), merchandise or other assets
are exchanged for cash or claims to cash...[and] when related assets
received or held are readily convertible to known amounts of cash or claims
to cash....Revenues are not recognized until earned ...when the entity has
substantially accomplished what it must do to be entitled to the benefits
represented by the revenues." Almost invariably, gain contingencies do not
meet these revenue recognition criteria.

Note: Bold print and italics added by me.

Overstock.com "substantially accomplished what it
must do to be entitled to the benefits represented by the revenues" since
the fulfillment partners were "contractually obligated" to pay underbilled
amounts. Those underbilled "fees and charges" were "realizable" as evidenced
by the fact that the company already collected a total of “$1.8 million
relating to payments from partners who were underbilled earlier in the year"
within a mere 68 days of announcing its billing errors.

If we follow guidance by Overstock.com's fiscal
year 2008 auditors, the amounts due from underbilling fulfillment partners
cannot be considered a gain contingency, as claimed by the company.
PricewaterhouseCoopers was subsequently terminated as Overstock.com's
auditors and replaced by Grant Thornton.

Q1 2009

In Q1 2009, even more amounts from underbilling
fulfillment partners were recovered. In addition, the company disclosed a
new accounting error by failing to book a “refund due of overbillings by a
freight carrier for charges from Q4 2008.” See quote from 10-Q report below:

In the first quarter of 2009, we reduced total cost
of goods sold by $1.9 million for billing recoveries from partners who were
underbilled in 2008 for certain fees and charges that they were
contractually obligated to pay, and a refund due of overbillings by a
freight carrier for charges from the fourth quarter of 2008. When the
underbilling and overbillings were originally discovered, we determined that
the recovery of such amounts was not assured, and that consequently the
potential recoveries constituted a gain contingency. Accordingly, we
determined that the appropriate accounting treatment for the potential
recoveries was to record their benefit only when such amounts became
realizable (i.e., an agreement had been reached with the other party and the
other party had the wherewithal to pay).

Note: Bold print and italics added by me.

Overstock.com continued to improperly recognize
deferred income from previously underbilling fulfillment partners. The new
auditors, Grant Thornton, would be wise to review Overstock.com's accounting
treatment of billing errors and recommend that its clients restate affected
financial reports to comply with GAAP. Otherwise, they should not give the
company a clean audit opinion for 2009.

Using accounting errors to previous quarters to
boost profits in future quarters

… Overstock.com managed to turn a controversial
fourth-quarter profit last year after discovering that it had underbilled
its fulfillment partners to the tune of $1.8-million earlier in the year.
Rather than backing that amount out into the appropriate periods,
Overstock.com reported it as one-time gain and reduced the cost of goods
sold for the quarter by $1.8-million. That bit of accounting turned what
would have been an $800,000 fourth-quarter loss into a $1-million profit.

As it turns out, Overstock.com managed to find some
more money that it used to reduce the cost of goods sold for the first
quarter of 2009, too.

"In Q1 2009, we reduced total cost of goods sold by
$1.9-million for recoveries from partners who were underbilled in 2008 for
certain fees and charges that they were contractually obligated to pay and a
refund due of overbillings by a freight carrier for charges from Q4 2008,"
the company disclosed.

"We just keep squeezing the tube of toothpaste
thinner and thinner and finding new stuff to come out," Mr. Byrne remarked
during the conference call after chief financial officer Steve Chesnut said
that the underbilling and overbilling had been found "as part of good
corporate diligence and governance."

In addition, Overstock.com managed to record a
$1.9-million gain, reported as part of "other income," by extinguishing
$4.9-million worth of its senior convertible notes, which it bought back at
rather hefty discount. If not for the fortuitous 2008 underbilling
recoveries, fourth-quarter overbillings refund and the paper gain from
extinguishing some of its debt, Overstock.com would have tallied a
first-quarter loss of $5.9-million or approximately 26 cents per share.

So, while Overstock.com did not manage to conjure
up a first-quarter profit by using the same accounting abracadabra employed
in the fourth quarter, it did succeed in trimming its net loss to
$2.1-million.

So just as part of good corporate diligence and
governance we've found these items.

Note: Bold print and italics added by me.

Actually, it was bad corporate diligence and
governance by CEO Patrick Byrne that caused the accounting errors to happen
by focusing on a vicious retaliatory smear campaign against critics, while
he runs his company into the ground with $267 million in accumulated losses
to date and never reporting a profitable year.

Memo to Grant Thornton (Overstock.com's new
auditors)

Overstock.com is a company that has not produced a
single financial report prior to Q3 2008 in compliance with Generally
Accepted Accounting Principles and Securities and Exchange Commission
disclosure rules from its inception, without having to later correct them,
unless such reports were too old to correct. Two more financial reports (Q4
2008 and Q1 2009) don't comply with GAAP and need to be restated, too.

Don’t laugh too hard at Patrick Byrne’s explanation
of the repeated accounting errors and improper treatment of those errors, as
reported by Lee Webb of Stockwatch:

“We just keep squeezing the tube of toothpaste
thinner and thinner and finding new stuff to come out,” Mr. Byrne remarked
during the conference call after chief financial officer Steve Chesnut said
that the underbilling and overbilling had been found “as part of good
corporate diligence and governance.”

Good corporate diligence and governance? Is this
guy for real? How about having an accounting system that prevents errors
from occurring every quarter?

Of course, Overstock.com management has to explain
away why Sam Antar is finding all these manipulations and irregularities in
their financial reporting. They can stalk and harass him all they want, call
him a criminal all they want, but there is no explaining it away. The
numbers don’t lie. Overstock.com just always counted on no one being as
thorough as Sam.

Professor Ketz Asserts Other Comprehensive Income (OCI from FAS 130)
may be More Important to Study Than Reported Income

"Citigroup Remains in Critical Condition," by: J. Edward Ketz , SmartPros,
May 2009 ---
http://accounting.smartpros.com/x66534.xml
Note that all Citigroup dollar amounts are in millions of dollars such that
$(27,684) is really a $27,684,000,000 billion loss.

The stress tests conducted by the Fed are a farce
inasmuch as the stress isn't too strenuous. That the Fed ascertained
additional capital requirements for several banks merely points out the
obvious - the banking sector remains in serious trouble.

That the financial industry was and remains in
trouble is not revelatory to those who pay attention to fair value
measurements. Take Citigroup for instance. This firm, once a giant among
banks, now gasps for its existence.

Citi’s reported net income was $(27,684) for 2008
(all accounting numbers in millions of dollars). While this is a smelly
number, the odor grows worse when one adjusts it for various items that
bypass the income statement.

Ever since the FASB invented the comprehensive
income statement in a political move to get business enterprises to do some
accounting for items they didn’t want to disclose, I have advocated that
investors use comprehensive income instead of net income. Comprehensive
income includes relevant items that have had a real economic impact on the
business entity; therefore, investors will find these items informative.

For fiscal 2008, Citi shows unrealized losses on
its available-for-sale securities of $(10,118). It also shows a loss on the
foreign currency translation adjustment of $(6,972), a loss on its cash flow
hedges of $(2,026), and a loss for additional pension liability adjustment
of $(1,419). This makes Citi’s comprehensive income $(48,219).

But the bad news doesn’t end there. The pension
footnote (footnote 9) shows the expected rate of return is 7.75%. While this
is what is required per FAS 87, it is nonsense. Did anybody know the 2008
rate of return in (say) 2005? The FASB should get rid of such fantasyland
assumptions and require business enterprises to employ the actual rate of
return. If Citi had done so on its pension assets, it would have had an
actual return of (5.42)%, so we shall adjust downward the 2008 income by
another $1,370.

The most interesting item is Citi’s move with
respect to its investments. It reports debt securities in its 2007
held-to-maturity portfolio of only $1. By year end 2008, however, this
amount mushroomed to $64,459. Clearly, Citi is shielding these debt
instruments from fair value accounting and the reporting of additional
losses. Footnote 16 indicates that these losses for 2008 amounted to
$(4,082).

Another item concerns the firm’s deferred income
tax assets. For 2008, Citi discloses $52,079 in deferred income tax assets
and a valuation allowance of zero. Given that Citi paid no federal income
taxes in 2007 or 2008 and likely will pay no federal income taxes in the
near future, if ever, how can the company justify a valuation allowance of
zero? Whatever amount it should be would further reduce the profits of the
firm. Since we don’t know how to estimate this valuation allowance
correctly, we shall continue to hold its balance at zero, even though this
is clearly wrong.

Putting these considerations together, Citigroup
has an adjusted income in 2008 of $(53,671). This is still an estimate but
clearly it is more nearly accurate than the reported number. And it reveals
that Citi lost twice as much as it reported.

Recently, we have been hearing how Citi has turned
things around and that the first quarter in 2009 returns Citi to the black
column with a profit of $1,593. Don’t believe a word of it!

Items in comprehensive income shows a modest gain
in the available-for-sale portfolio of $20, gains on cash flow hedges of
$1,483, and a gain because of the pension liability adjustment of $66.
Unfortunately, these gains are wiped out by a loss in the foreign currency
translation adjustment of $(2,974). Comprehensive remains ugly at $(225).

We don’t have any disclosure in the quarterly
report about actual versus expected returns on pension assets, so we cannot
adjust them to show the truth.

But, the strategy to move debt securities from
available-to-sale to held-to-maturity paid off significantly. First quarter
results show a staggering loss on these securities of $(7,772).

So far, the adjusted earnings for Citigroup for the
first quarter of 2009 is $(7,584). Don’t tell me that Citi has improved its
operations.

Further, these numbers have been improved by an
eccentricity in FAS 157. For some silly reason, the board allows entities to
show a gain on their liabilities if the firm’s own credit risk has
increased. This takes a perfectly good notion of fair value of liabilities
to an absurd result. Failing companies might be able to make liabilities
disappear by claiming a sufficiently high increase in their own credit
ratings! Utter rubbish—and the FASB should amend its statement.

Citi disclosed in a conference call that the first
quarter results include a gain of $2,700 because of this increase in its own
nonperformance risk. This gain is total nonsense, so I would adjust
quarterly income further, giving Citi adjusted earnings of $(10,284).

Citigroup suffered a cardiac arrest in 2008, and it
remains in critical condition. Any other conclusion is propaganda or self
deception. And forget the stress tests; they are so flawed that Lehman
Brothers might pass them. The Fed says that Citi needs another $5,500 in
capital to weather any additional economic crises it might face. It isn’t
true. Citi needs a lot more capital than that just to weather current
conditions. If a real crisis occurs, Citi will become a flat-liner; it might
die anyway.

If you want to protect your portfolio, don’t listen
to the optimistic forecasts coming from Washington and don’t stop at the
reported income number. Look at the fair value disclosures within SEC
filings, adjust reported earnings for these fair value gains and losses, and
then you will obtain the truth.

JPMorgan Chase may be sued by US regulators for
violating securities laws and market rules related to the sale of bonds and
interest-rate swaps to Jefferson County, Alabama.

The potential Securities and Exchange Commission
action is the latest twist in a complex debt financing saga which has
already led to charges against Jefferson County officials and which has left
the municipality struggling to avoid default on over $3bn of debt, much of
it taken on to improve its sewage system.

JPMorgan said in a regulatory filing, made late on
Thursday just as the results of bank stress tests were being released, that
it had been told about the SEC action on April 21. It said it “has been
engaged in discussions with the SEC staff in an attempt to resolve the
matter prior to litigation”. The bank had no further comment on Friday.

Jefferson County is one of the most indebted
municipalities in the US due to its expensive overhaul of its sewage system.
JPMorgan is one of the lenders which has repeatedly extended the deadline on
payments due by Jefferson County on its debt and derivatives.

A law is currently being considered that would
create a new tax which would provide revenues to pay the sewer debt. If
Jefferson County defaults, it would be the biggest by a US municipality,
dwarfing the problems faced by California’s Orange County in the 1990s.

The mayor of Birmingham, Alabama, and two of his
friends were last year charged by US regulators in connection with an
undisclosed payment scheme related to municipal bond and swap deals.

The SEC alleged that Larry Langford, the mayor,
received more than $156,000 in cash and benefits from a broker hired to
arrange bond offerings and swap agreements on behalf of Jefferson County,
where Birmingham is located.

Although the details of the SEC investigation are
not known, it is likely to be related to the payment scheme through which
banks like JPMorgan paid fees to local brokers at the request of Jefferson
County.

The credit crisis has brought to light numerous
problems in the municipal bond markets. Many borrowers relied on bond
insurance to sell their deals, and the collapse in the credit ratings of
bond insurers has made it difficult for many to raise funds or to do so at
low interest rates.

Reports are surfacing that CPA
auditors were warned about toxic assets and pending bank failures.
Yet virtually all of the failed banks in 2008 and early 2009 received clean
audit opinions not warning of "going concern" weaknesses

Aside from the massive lawsuits that have been or will soon
be filed against banks, mortgage finance companies, and their auditors, it the
big question will be investigations of the PCAOB into those failed audits. The
Federal Government PCAOB's reputation is somewhat at stake here ---
http://www.pcaobus.org/

Where were the giant accounting
firms, the CPAs, and the rest of the accounting profession while the Wall
Street towers of fraud, deception and cover-ups were fracturing our economy,
looting and draining trillions of dollars of other peoples’ money?

This is the licensed profession
that is paid to exercise independent judgment with independent standards to
give investors, pension funds, mutual funds, and the rest of the financial
world accurate descriptions of corporate financial realities.

It is now obvious that the
accountants collapsed their own skill, integrity and self-respect faster and
earlier than the collapse of Wall Street and the corporate barons. The
accountants—both external and internal—could have blown the whistle on what
Teddy Roosevelt called the “malefactors of great wealth.”

The Big Four auditors knew what was
going on with these complex, abstractly structured finance instruments,
these collateralized debt obligations (CDOs) and other financial products
too abstruse to label. They were on high alert after early warning scandals
involving Long Term Capital Management, Enron, and others a decade or so
ago. These corporate casino capitalists used the latest tricks to cook the
books with many of the on-balance sheet or off-balance sheet structured
investment vehicles that metastasized big time in the first decade of this
new century. These big firms can’t excuse themselves for relying on
conflicted rating companies, like Moody’s or Standard & Poor, that gave
triple-A ratings to CDO tranches in return for big fees. Imagine the
conflict. After all, “prestigious” outside auditors were supposed to be on
the inside incisively examining the books and their footnotes, on which the
rating firms excessively relied.

Let’s be specific with names. Carl
Olson, chairman of the Fund for Stockowners Rights wrote in the letters
column of The New York Times Magazine (January 28, 2009) that
“PricewaterhouseCoopers O.K.’d AIG and FreddieMac. Deloitte & Touche
certified Merrill Lynch and Bear Stearns. Ernst & Young vouched for Lehman
Brothers and IndyMac Bank. KPMG assured over Countrywide and Wachovia. These
‘Big Four’ C.P.A. firms apparently felt they could act with impunity.”
“Undoubtedly they knew that the state boards of accountancy,” continued Mr.
Olson, “which granted them their licenses to audit, would not consider these
transgressions seriously. And they were right…Not one of them has taken up
any serious investigation of the misbehaving auditors of the recent debacle
companies.”

“Misbehaving” is too kind a word.
The “Big Four” destroyed their very reason for being by their involvement in
these and other boondoggles that have made headlines and dragooned our
federal government into bailing them out with disbursements, loans and
guarantees totaling trillions of dollars. “Criminally negligent” is a better
phrase for what these big accounting firms got rich doing—which is to look
the other way.

Holding accounting firms like these
accountable is very difficult. It got more difficult in 1995 when Congress
passed a bill shielding them from investor lawsuits charging that they
“aided and abetted” fraudulent or deceptive schemes by their corporate
clients. Clinton vetoed the legislation, but Senator Chris Dodd (D-CT) led
the fight to over-ride the veto.

Moreover, the under-funded and
understaffed state boards of accountancy are dominated by accountants and
are beyond inaction. What can you expect?

As for the Securities and Exchange
Commission (SEC), “asleep at the switch for years” would be a charitable
description of that now embarrassed agency whose mission is to supposedly
protect savers and shareholders. This agency even missed the massive Madoff
Ponzi scheme.

The question of accounting probity
will not go away. In the past couple of weeks, the non-profit Financial
Accounting Standards Board (FASB)—assigned to be the professional conscience
of accountancy—buckled under overt pressure from Congress and the banks. It
loosened the mark-to-market requirement to value assets at fair market value
or what buyers are willing to pay.

This decision by the FASB is
enforceable by the SEC and immediately “cheered Wall Street” and pushed big
bank stocks upward. Robert Willens, an accounting analyst, estimated this
change could boost earnings at some banks by up to twenty percent. Voilà,
just like that. Magic!

Overpricing depressed assets may
make bank bosses happy, but not investors or a former SEC Chairman, Arthur
Levitt, who was “very disappointed” and called the FASB decision “a step
toward the kind of opaqueness that created the economic problems that we’re
enduring today.”

To show the deterioration in
standards, banks tried to get the FASB and the SEC in the 1980s to water
down fair-value accounting during the savings and loan failures. Then-SEC
Chairman Richard Breeden refused outright. Not today.

Former SEC chief accountant, Lynn
Turner, presently a reformer of his own profession, supports mark-to-market
or fair value accounting as part of bringing all assets and liabilities,
including credit derivatives, back on the balance sheets of the financial
firms. He wants regulation of the credit rating agencies, mortgage
originators and the perverse incentives that lead to making bad loans. He
even wants the SEC to review these new financial products before they come
to market, eliminating “hidden financing.”

Now comes the life insurance
industry, buying up some small banks to qualify for their own large federal
bailouts for making bad, risky speculations.

The brilliant Joseph M. Belth,
writing in his astute newsletter, the Insurance Forum (May 2009), noted that
life insurers are lobbying state insurance departments to weaken statutory
accounting rules so as to “increase assets and/or decrease liabilities.”
Some states have already caved. Again, voilà, suddenly there is an increase
in capital. Magic. Here we go again.

Who among the brainy, head up accountants, in practice or in academia, will
join with Lynn Turner and rescue this demeaned, chronically rubber-stamping
“profession,” especially the “Big Four,” from its pathetic pretension for
which tens of millions of people are paying dearly?

Reports are surfacing that CPA
auditors were warned about toxic assets and pending bank failures.
Yet virtually all of the failed banks in 2008 and early 2009 received clean
audit opinions not warning of "going concern" weaknesses

Aside from the massive lawsuits that have been or will soon
be filed against banks, mortgage finance companies, and their auditors, it the
big question will be investigations of the PCAOB into those failed audits. The
Federal Government PCAOB's reputation is somewhat at stake here ---
http://www.pcaobus.org/

Where were the giant accounting
firms, the CPAs, and the rest of the accounting profession while the Wall
Street towers of fraud, deception and cover-ups were fracturing our economy,
looting and draining trillions of dollars of other peoples’ money?

This is the licensed profession
that is paid to exercise independent judgment with independent standards to
give investors, pension funds, mutual funds, and the rest of the financial
world accurate descriptions of corporate financial realities.

It is now obvious that the
accountants collapsed their own skill, integrity and self-respect faster and
earlier than the collapse of Wall Street and the corporate barons. The
accountants—both external and internal—could have blown the whistle on what
Teddy Roosevelt called the “malefactors of great wealth.”

The Big Four auditors knew what was
going on with these complex, abstractly structured finance instruments,
these collateralized debt obligations (CDOs) and other financial products
too abstruse to label. They were on high alert after early warning scandals
involving Long Term Capital Management, Enron, and others a decade or so
ago. These corporate casino capitalists used the latest tricks to cook the
books with many of the on-balance sheet or off-balance sheet structured
investment vehicles that metastasized big time in the first decade of this
new century. These big firms can’t excuse themselves for relying on
conflicted rating companies, like Moody’s or Standard & Poor, that gave
triple-A ratings to CDO tranches in return for big fees. Imagine the
conflict. After all, “prestigious” outside auditors were supposed to be on
the inside incisively examining the books and their footnotes, on which the
rating firms excessively relied.

Let’s be specific with names. Carl
Olson, chairman of the Fund for Stockowners Rights wrote in the letters
column of The New York Times Magazine (January 28, 2009) that
“PricewaterhouseCoopers O.K.’d AIG and FreddieMac. Deloitte & Touche
certified Merrill Lynch and Bear Stearns. Ernst & Young vouched for Lehman
Brothers and IndyMac Bank. KPMG assured over Countrywide and Wachovia. These
‘Big Four’ C.P.A. firms apparently felt they could act with impunity.”
“Undoubtedly they knew that the state boards of accountancy,” continued Mr.
Olson, “which granted them their licenses to audit, would not consider these
transgressions seriously. And they were right…Not one of them has taken up
any serious investigation of the misbehaving auditors of the recent debacle
companies.”

“Misbehaving” is too kind a word.
The “Big Four” destroyed their very reason for being by their involvement in
these and other boondoggles that have made headlines and dragooned our
federal government into bailing them out with disbursements, loans and
guarantees totaling trillions of dollars. “Criminally negligent” is a better
phrase for what these big accounting firms got rich doing—which is to look
the other way.

Holding accounting firms like these
accountable is very difficult. It got more difficult in 1995 when Congress
passed a bill shielding them from investor lawsuits charging that they
“aided and abetted” fraudulent or deceptive schemes by their corporate
clients. Clinton vetoed the legislation, but Senator Chris Dodd (D-CT) led
the fight to over-ride the veto.

Moreover, the under-funded and
understaffed state boards of accountancy are dominated by accountants and
are beyond inaction. What can you expect?

As for the Securities and Exchange
Commission (SEC), “asleep at the switch for years” would be a charitable
description of that now embarrassed agency whose mission is to supposedly
protect savers and shareholders. This agency even missed the massive Madoff
Ponzi scheme.

The question of accounting probity
will not go away. In the past couple of weeks, the non-profit Financial
Accounting Standards Board (FASB)—assigned to be the professional conscience
of accountancy—buckled under overt pressure from Congress and the banks. It
loosened the mark-to-market requirement to value assets at fair market value
or what buyers are willing to pay.

This decision by the FASB is
enforceable by the SEC and immediately “cheered Wall Street” and pushed big
bank stocks upward. Robert Willens, an accounting analyst, estimated this
change could boost earnings at some banks by up to twenty percent. Voilà,
just like that. Magic!

Overpricing depressed assets may
make bank bosses happy, but not investors or a former SEC Chairman, Arthur
Levitt, who was “very disappointed” and called the FASB decision “a step
toward the kind of opaqueness that created the economic problems that we’re
enduring today.”

To show the deterioration in
standards, banks tried to get the FASB and the SEC in the 1980s to water
down fair-value accounting during the savings and loan failures. Then-SEC
Chairman Richard Breeden refused outright. Not today.

Former SEC chief accountant, Lynn
Turner, presently a reformer of his own profession, supports mark-to-market
or fair value accounting as part of bringing all assets and liabilities,
including credit derivatives, back on the balance sheets of the financial
firms. He wants regulation of the credit rating agencies, mortgage
originators and the perverse incentives that lead to making bad loans. He
even wants the SEC to review these new financial products before they come
to market, eliminating “hidden financing.”

Now comes the life insurance
industry, buying up some small banks to qualify for their own large federal
bailouts for making bad, risky speculations.

The brilliant Joseph M. Belth,
writing in his astute newsletter, the Insurance Forum (May 2009), noted that
life insurers are lobbying state insurance departments to weaken statutory
accounting rules so as to “increase assets and/or decrease liabilities.”
Some states have already caved. Again, voilà, suddenly there is an increase
in capital. Magic. Here we go again.

Who among the brainy, head up accountants, in practice or in academia, will
join with Lynn Turner and rescue this demeaned, chronically rubber-stamping
“profession,” especially the “Big Four,” from its pathetic pretension for
which tens of millions of people are paying dearly?

The Fate of the Large Auditing Firms After the 2008
Banking Meltdown

Questions
Where were the auditors when auditing those risky investments and bad debt
reserves of the ailing banks?Answer: Not sure.

Where will the auditors be in after the shareholders in the failing banks lose
all or almost all in the meltdowns?Answer: In court, because the shareholders are the
fall guys not being bailed out in when banks declare bankruptcy or are bought
out cheap just before declaring bankruptcy.
Shareholder will understandably turn to the deep pocket auditors.

It seems like just a few months ago
— because it was — that trial lawyers, those advocates who take on companies
on behalf of investors, customers or even other businesses, had a wretched
reputation. Three of the best known of those lawyers, William S. Lerach,
Melvyn I. Weiss and Richard F. Scruggs, had all pleaded guilty to crimes.
Defense lawyers were gleeful.

But the pendulum has shifted again,
much as in the years after the collapse of Enron and WorldCom.

Accusations of executive excess,
accounting fraud and lack of disclosure are far more credible now, since bad
bets on real estate and securities linked to home loans have caused some of
the biggest and most prestigious financial firms in the country — Lehman
Brothers, the American International Group, Fannie Mae, Freddie Mac — to
collapse, sell parts of themselves at fire-sale prices or suffer outright
government takeovers. A legal argument rarely used in investor lawsuits is
tempting: res ipsa loquitur, or the thing speaks for itself.

“There’s clearly going to be an
erosion in the presumption that these senior-ranking executives should be
given the benefit of the doubt,” said John P. Coffey, a partner at Bernstein
Litowitz Berger & Grossmann, adding that as a result of regulators’
investigations and angry former employees, there is also more information
available to plaintiffs about questionable conduct. “There’s clearly going
to be an effect there; judges are human.”

So are investors, who are angry.
Individual shareholders as well as big companies want someone else to pay
for their losses on investments in everything from basic stocks to exotic
swaps. And lawyers are emboldened in their claims by the huge losses and
obvious errors in judgment at companies that, until recently, confidently
asserted their immunity to market turbulence.

Investors’ lawyers can point at
statements and actions by regulators to bolster their claims. In a suit
filed in mid-September by Fannie Mae shareholders, the plaintiffs blamed a
government plan to buy shares of the company and then take it over for
helping to depress the company’s stock price. The lawsuit names Merrill
Lynch, Citigroup, Morgan Stanley and others as defendants, accusing them of
making false statements about Fannie Mae’s financial condition.

“The more you think about it,
there’re so many different ways that so many different people could be
responsible for this,” said H. Adam Prussin, a partner at Pomerantz Haudek
Block Grossman & Gross, referring to losses suffered in this financial
crisis. His firm is representing Fannie Mae investors. “There are the
lenders who screwed up in the first place, there are the people who bought
these things from the lenders and then didn’t account correctly for them.”

A recent report by the law firm
Fulbright & Jaworski found that more than one-third of lawyers working
internally for companies expected to see more litigation in 2009. Lawyers at
the biggest companies were more likely to expect a boom in lawsuits,
according to the study.

One factor contributing to
litigation is the rapid availability of information about corporate mistakes
and losses, which in the past might have taken longer to circulate among
investors, said Michael Young, a partner at Willkie Farr & Gallagher in New
York.

“What’s really going on here is a
type of accounting that is capturing changes in value and making them public
much faster than anything we’ve seen before,” Mr. Young said.

Armed with such data, shareholders
have charged the courthouse steps, claiming that companies failed to
disclose their vulnerability to declines in the real estate market, often
through holdings of securities backed by home loans. Even companies that
have suffered huge losses may still be worth pursuing because of their
liability insurance.

“You can’t get blood from a stone,”
said Joseph A. Grundfest, a former commissioner of the Securities and
Exchange Commission who now teaches at Stanford Law School. “But you sure
can get money from the insurance company that covered the stone.”

There are other deep pockets, even
in the current economic climate. When confronted by bankruptcy filings or
government takeovers, the lawsuits name every possible defendant involved in
a stock offering — the underwriters, the rating agencies and individual
executives — but not the issuing company itself. That way, they avoid the
problem of fighting with other creditors in bankruptcy or the question of
whether they can sue the government.

In the case brought by Fannie
shareholders, for example, Fannie itself is not a defendant. A suit filed
last month by investors who bought Freddie Mac shares names only Goldman
Sachs, JPMorgan Chase and Citigroup. The suit claims that the investment
firms, which underwrote a Freddie Mac stock offering, did not disclose the
company’s “massive exposure to mortgage-related losses.” (JPMorgan Chase did
not underwrite the offering itself but it acquired Bear Sterns, which did).

Events have moved quickly enough
that some lawyers have found that their lawsuits may have been filed too
early, before the biggest losses and consequently before the biggest damage
claims were possible.

Ever since Arthur Andersen left the
market after its scandalous role in the fall of Enron, people have been
asking how long it will be before another big firm follows suit. The (UK)
Financial Reporting Council (FRC) has been trying ever since to make sure
that the Big Four will be protected if found guilty of similar negligence.
The introduction of limited liability should help, but given the
accelerating meltdown of the global financial system, will it be enough?

As always, and as was the case with
Arthur Andersen, it will be events in America that determine the fate of the
Big Four. This summer the U.S. Treasury's Advisory Committee of the Auditing
Profession met in Washington and heard that between them the six largest
firms had 27 outstanding litigation proceedings against them with damage
exposure above $1 billion, seven of which exceed $10 billion. It is
impossible to buy insurance that will cover such catastrophic liability and
any one of them, if successful, could prove a fatal blow.

That U.S. Treasury committee met
again last week to discuss the viability of limited liability for auditors
in the U.S., but the 21-strong panel decided against it. With that, the hope
of some silver bullet solution to the Big Four's problems expired. Committee
member Lynn Turner, formerly a chief accountant to the Securities and
Exchange Commission (SEC), was plainly baffled such an idea had even been
seriously suggested.

"Do you believe that an auditor
found to have been aware of financial reporting problems but never reporting
them to the public should be the subject of liability caps or some type of
litigation reform protecting them?" he asked. Turner summed the situation up
nicely when he described the big accounting firms as a "federally mandated
and authorized cartel" which was "too big to [be allowed to] fail".

When Arthur Andersen went down six
years ago, Turner had never been quite able to believe that the firm's bad
behavior had really been all that anomalous. "It's beyond Andersen," he told
CBS Frontline that same year, "it's something that's embedded in the system
at this time. This notion that everything is fine in the system just because
you can't see it is totally off-base."

The credibility of the markets

Looking at recent economic events,
Turner's suspicions that the credibility of the markets were at stake has
plainly proved prescient. So too may his belief that unethical accounting
was not so much a case of a few bad apples, but a bad barrel.

Consider some of the recent and
outstanding claims against the biggest six firms. In Miami last August a
jury ordered BDO Seidman to pay $521 million in damages for its negligence
in a Portuguese bank audit; almost as much as the firm's estimated revenue
for that year. In the U.S., banks and the shareholders of banks are
perfectly prepared to go after auditors, and when they win they tend to win
big. Note than when Her Majesty's Treasury hired the BDO's valuation partner
Andrew Caldwell for the controversial Northern Rock valuation, they hired
the man and not the firm. The firms are already worried enough about
litigation.

KPMG provides a clear example of
how the credit crunch might cull the Big Four. The firm was already looking
vulnerable before it hit: there was the 2005 'deferred prosecution'
agreement with the New York Attorney's Office, the damning German probe into
the Siemens bribery scandal, a lawsuit from superconductor company Vitesse
for 'audit failures' and a minor fine from the UK's Joint Disciplinary
Scheme (JDS) for allowing fraud to occur at Independent Insurance (it may
only have been half a million, but it was the JDS' biggest fine to date).
But when the subprime problems of U.S. lender New Century enter the picture,
the damages involved escalate drastically.

A U.S. Justice Department report
has already concluded that KPMG either helped perpetrate the fraud at the
mortgager or deliberately ignored it. Class-action lawsuits are already
pending. Only weeks before the report was published the U.S. Supreme Court's
Stone Ridge ruling immunized third party advisers like accountants and
bankers from the disgruntled shareholders of other entities, but that may be
not much of a shield. Of course, New Century might not be KPMG's biggest
problem. That's probably the Federal National Mortgage Association, or
Fannie Mae.

Fannie Mae initiated litigation way
back in 2006, and is trying to reclaim more than $2 billion from its old
auditors. That's on top of the $400 million KPMG agreed to pay the SEC to
settle the regulator's fraud allegations. Its defense so far has been one of
complete innocence, asserting that Fannie Mae successfully hid all evidence
of anything untoward. Now that the FBI is investigating the mortgage lender,
such a position will have to be abandoned if incriminating evidence turns
up. Ostensibly, the Federal investigation relates to Fannie Mae's
relationship with ratings agencies, but you never know what will fall out of
the closet.

So KPMG is in a spot of bother, but
it's not alone. Ernst and Young will almost inevitably see itself in court
over the demise of its audit client Lehman Brothers. Similarly,
PricewaterhouseCoopers is surely going to feel some heat for its auditing of
what was once the world's largest insurance company, AIG, assuming the
Northern Rock Shareholders Group doesn't take a pop at it first.

The most serious problem in the U.S.
audit model is that clients are becoming bigger and bigger due to
non-enforcement of anti-trust laws. For example, the merger of Mobile and Exxon
created an even larger single client. The merger of Bear Stearns and JP Morgan
created a much larger client. The number of potential clients is shrinking while
the size of the clients is exploding. According to the CEO of Bank of America,
in a CBS Sixty Minutes interview on October 19, 2008, half of all banking
customers in the United States now have accounts with Bank of America. That was
before Bank of America bought out Merrill Lynch.

As these giants merge to become bigger
giants, it gets to a point where their auditors cannot afford to lose a giant
client producing upwards of $100 million in audit revenue each year. Real
independence of audits breaks down because a giant client can become a bully
with its audit firm fearful of losing giant clients.

Enron was an extreme but not necessarily
an outlier. It will most likely be alleged in court over the next few years that
giant Wall Street banks bullied their auditors into going along with
understating financial risk before the 2008 banking meltdown. We certainly
witnessed the understating of financial risk in 2007 and 2008.

It must be kept in mind that the
statements certified are not ours but are our clients--and our clients do not
care to mix explanations of accounting theory with explanations of their
business nor can we pass onto our readers the responsibility for appraisal of
differences in accounting theory. Those fields are for you and me to grapple
with, not the public. In general, clients are not primarily interested in
arguments of accounting theory at the time of preparing their reports. The
companies whose accounts are certified are chiefly interested in what is said to
their shareholders, and in the hard practical facts of how accounting rules
affect them, their competitors and other companies. Usually they are very
critical of what we call accounting principles when these called principles are
unrealistic, inconsistent, or do not protect or distinguish scrupulous
management from the scrupulous.
"The Need for An Accounting Court," by Leonard Spacek, The Accounting
Review, 1958, Pages 368-379 ---
http://www.trinity.edu/rjensen/FraudSpacek01.htm

Jensen Comment
Fifty years later I'm a strong advocate of an accounting court, but I envision a
somewhat different court than envisioned by the great Leonard Spacek in 1958.
Since 1958, the failure of anti-trust enforcement has allowed business firms to
merge into enormous multi-billion or even trillion dollar clients who've become
powerful bullies that put extreme pressures on auditors to bend accounting and
auditing principles. For example see the way executives of Fannie Mae pressured
KPMG to bend the rules (an act that eventually got KPMG fired from the audit).

In my opinion the time has come where auditors and clients
can take their major disputes to an Accounting Court that will use expert
independent judges to resolve these disputes much like the Derivatives
Implementation Group (DIG)
resolved technical issues for the implementation of FAS 133. The main
difference, however, is that an Accounting Court should hear and resolve
disputes in private confidence that allows auditors and clients to keep these
disputes away from the media. The main advantage of such an Accounting Court is
that it might restrain clients from bullying auditors such as became the case
when Fannie Mae bullied KPMG.

Who would sit on accounting courts is
open to debate, but the "judges" could be formed by the State Boards of
Accountancy much like a grand jury is formed by a court of law. Accounting court
cases, however, should be confidential since they deal with sensitive client
information.

I really don't anticipate a flood o
cases in an accounting court. But I do view the threat of taking client-auditor
disputes to such courts (in confidence) as a means of curbing the bullying of
auditors by their enormous clients.

The problem is that poor anti-trust
enforcement coupled with mergers of huge companies have combined to create
mega-clients that auditing firms cannot afford to lose after gearing up to
handle such large clients. I think we saw this in the "clean opinions" given to
all the enormous failing banks (like WaMu) and enormous Wall Street investment
banks (like Lehman). The big auditing firms just could not afford to question
bad debt estimates, mortgage application lies, and CDO manipulations of such
clients.

I find it hard to believe that auditors
failed to detect an undercurrent of massive subprime "Sleaze, Bribery, and Lies"
that transpired in the Main Street banks and mortgage lending companies ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
The sleaze was so prevalent the auditors must've worn their chest-high waders on
these audits

Bob Jensen's threads on the fate of the large auditing firms following the
subprime scandals ---

The business sector of Vienna suffered long and
hard during the economic crisis which beset Austria starting in
approximately 1846. It was not until 1855 that merchants, from wholesalers
to sales personnel, had recovered sufficiently to recognise the growing
importance of the merchant class with their own ball to be held at Sperl’s
during the Carnival season. On that occasion, Johann Strauss played his
high-spirited Handels-Elite-Quadrille, Op. 166, for the first time at
Sperl’s. On 21st February 1859, another ball of this kind was held, this
time in the elegant Sofiensaal. The Strauss orchestra was again hired to
provide the music, but Johann Strauss did not appear before his musicians on
this evening, leaving the ball to his brother Josef, who contributed the
traditional dedication piece, the waltz Soll und Haben.

On the following day, the Theaterzeitung had this
to say, among other things: "The attendance was quite numerous.
Overcrowding, however, was not a problem and did not interfere with the
guests’ dancing enjoyment, especially by youthful revellers. The festival
took place amidst unspoilt and unbridled merriment. The dresses of the
ladies were splendid. Of the waltzes presented by Strauss for this occasion,
the one entitled Soll und Haben was the best". The publisher Carl Haslinger
took his time to release the work, issuing it on 21st August 1859 under the
double title Soll und Haben - Handels-Elite-Ball-Tänze. Although it was not
possible to confirm whether or not the instrumental parts were ever printed,
they were easy to reproduce, because the printing dies were available as a
source."

The entire STRAUSS, Josef: Edition - Vol. 25
recording can be purchased and downloaded from
http://www.naxos.com/catalogue/item.asp?item_code=8.223664 . The single,
9-minute Debit and Credit Waltz track can also be purchased and downloaded.
Of course, the traditional CD format is available through Amazon.

May 25, 2009 reply from Bob Jensen

Hi Barry, It’s amazing how virtually all accountants think of the ledger
when they see the phrase “Debit and Credit.” This most likely was the 19th
Century context when for the "Debit and Credit Waltz" by Josef Strauss.

"The power of double-entry bookkeeping has been
praised by many notable authors throughout history. In Wilhelm Meister,
Goethe states, "What advantage does he derive from the system of
bookkeeping by double-entry! It is among the finest inventions of the
human mind"... Werner Sombart, a German economic historian, says, "...
double-entry bookkeeping is borne of the same spirit as the system of
Galileo and Newton" and "Capitalism without double-entry bookkeeping is
simply inconceivable. They hold together as form and matter. And one may
indeed doubt whether capitalism has procured in double-entry bookkeeping
a tool which activates its forces, or whether double-entry bookkeeping
has first given rise to capitalism out of its own (rational and
systematic) spirit".
You can read about Werner Sombart at
http://en.wikipedia.org/wiki/Werner_Sombart#Works_by_Sombart

Thank you Barry. I never heard of this Straus composition until now,
although in the 21st Century there are a number of YouTube “debit and
credit” rap songs in the context of “Debit Card” versus “Credit Card” ---
banking cards that did not exist in the 19th Century.

For 1984-2006...mutual funds on average and the
average dollar invested in funds underperform three-factor and four-factor
benchmarks by about the amount of costs (fees and expenses). Thus, if there are
fund managers with skill that enhances expected returns relative to passive
benchmarks, they are offset by managers whose stock picks lower expected
returns. We attempt to identify the presence of skill via bootstrap simulations.
The tests for net returns say that even in the extreme right tails of the
cross-sections of three-factor and four-factor t(α) estimates, there is no evidence of fund managers with skill
sufficient to cover costs.Eugene F. Fama and Kenneth R. French, "Luck versus Skill in the Cross
Section of Mutual Fund Alpha Estimates," SSRN, March 9, 2009 ---
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021

Abstract:
The aggregate portfolio of U.S. equity mutual funds is close to the market
portfolio, but the high costs of active management show up intact as lower
returns to investors. Bootstrap simulations produce no evidence that any
managers have enough skill to cover the costs they impose on investors. If
we add back costs, there is some evidence of inferior and superior
performance (non-zero true alpha) in the extreme tails of the cross section
of mutual fund alpha estimates. The evidence for performance is, however,
weak, especially for successful funds, and we cannot reject the hypothesis
that no fund managers have skill that enhances expected returns.

SUMMARY: The
World Bank's Independent Evaluation Group produced a report in fall
2008, which cited the bank's fraud-detection procedures in its main
program providing aid to poor countries as a material weakness. This $40
billion program is called the International Development Association
(IDA). "[World] Bank staffers said that the IDA program faces
particularly difficult challenges because corruption is often a problem
in especially poor countries....Generally, the IDA received good marks
and the results 'should overall be considered a quite respectable
outcome,' the report said."

CLASSROOM APPLICATION: The
application of internal control procedures, and their independent
testing, outside of corporations can be an eye-opener for students.

QUESTIONS:
1. (Introductory)
What is the World Bank?

2. (Introductory)
Who issued a report on the internal controls in place in World Bank
programs? Why was this review of internal controls undertaken?

3. (Advanced)
Describe a corporate function similar to the group that undertook the
review described in answer to question 2 above.

4. (Advanced)
Which World Bank program has been found to have material weaknesses in
control systems? What system has been found as a material weakness?

5. (Advanced)
Define the terms "material weakness" and "significant deficiency" in
relation to audits of corporate internal control systems.

6. (Advanced)
Do you think that the meaning of these terms in the report on World Bank
programs is the same as the definitions you have provided? Why or why
not?

The World Bank's fraud-detection procedures in its
main aid program to poor countries were labeled a "material weakness" in an
internal report, adding to the bank's woes in handling corruption issues.

The bank's Independent Evaluation Group gave it the
lowest possible rating for fraud-detection procedures in the $40 billion aid
program, called the International Development Association. That could hurt
contributions to the effort, which gives grants and interest-free loans to
the world's 78 poorest countries.

The 690-page report, the first for the program, was
completed last fall. Since then it has been the subject of lengthy
discussions between World Bank management and the independent evaluation
unit over whether the single designation of "material weakness," the lowest
of four ratings, was justified. None of the program's other marks were as
low; six other areas were labeled "significant deficiencies."

"The bank's traditional control systems weren't
designed to address fraud and corruption," one of the report's authors, Ian
Hume, said in an interview. "They were designed for efficiency and equity --
the cheapest possible price." That increases the risk that corruption could
occur in the use of IDA grants, he said.

The World Bank has been pilloried by critics for
years for not taking corruption seriously enough, and some staffers worried
that the report's publication was being delayed for political reasons. The
U.S., in particular, pushed for its publication, said bank staffers.

"We have had a tough but cordial interaction with
[World Bank] management along the way," said Cheryl Gray, director of the
evaluation group.

The report was published on the unit's Web site
late Wednesday, but not publicized. Its presence was noted by a small icon
on the bottom right of the page. Ms. Gray says that the group didn't intend
to bury the report and said the unit didn't put out a press release because
the report was "technical and jargony." After an inquiry from The Wall
Street Journal, it was given greater prominence on the Web site. Ms. Gray
said she had planned to make the change anyway.

The report concluded that the World Bank "has until
recently had few if any specific tools" to directly address fraud and
corruption "at all stages in the lending cycle." An advisory panel that
backed the "material weakness" designation wrote that fraud and corruption
issues "involve a considerable reputation risk, involving at least a
potential loss of confidence by various stakeholders."

The Obama administration recently asked Congress to
approve a three-year, $3.7 billion contribution to the bank's IDA program. A
Democratic congressional staffer said it was too early to tell whether the
report would make passage more difficult. Overall, the World Bank won
commitments in December 2007 for $41.6 billion in funding for IDA over three
years.

Bank staffers said that the IDA program faces
particularly difficult challenges because corruption is often a problem in
especially poor countries. "We operate in some of the most difficult and
challenging environments in the world," Fayez Choudhury, the World Bank's
controller, said in an interview. "We are always looking to up our game."

The bank's management pressed to get the
fraud-and-corruption designation improved by a notch to "significant
deficiency." It argued that the evaluation group didn't take into account
steps it had taken over the past year to improve its controls.

"The bank is firmly committed to mainstreaming
governance and anticorruption efforts into its development work," said a
management statement. It listed a number of improvements including the
creation of an independent advisory board. The bank said it is trying to
better integrate fraud prevention and corruption prevention generally into
its operations.

The report doesn't examine cases of actual
corruption, though it notes there have been several instances that have
received publicity, including health-clinic contracts in India. Rather, it
looks at the systems and procedures in place to identify and prevent
corruption.

The report uses standards similar to those applied
to corporate controls. Generally, the IDA received good marks and the
results "should overall be considered a quite respectable outcome," the
report said.

For decades, the World Bank largely ignored
corruption, figuring that some graft was the price of doing business in poor
countries. Starting in 1996, however, former World Bank President James
Wolfensohn focused more attention on the issue, as did his successor, Paul
Wolfowitz, who held up loans to some poor countries because of concerns
about corruption. That led to charges that the bank was enforcing corruption
rules selectively.

After Mr. Wolfowitz came under fire earlier for
showing favoritism to his girlfriend, a bank employee, some developing
nations dismissed the bank's efforts as hypocritical. Mr. Wolfowitz resigned
in 2007 and the World Bank's current president, Robert Zoellick , has been
trying to depoliticize the corruption issue, especially by beefing up the
Department of Institutional Integrity, the main antifraud unit at the bank.

Reviews of other institutions have also turned up
designations of "material weakness." A U.S. Treasury "accountability report"
for the year ended Sept. 30, 2008, for instance, found four such
designations, including three involving the Internal Revenue Service's
modernization, computer security and accounting, and one involving
government-wide financial statements.

"Critics Pan New Financial Statements: A long-planned overhaul
of financial statements gets a rough reception from preparers at its initial
unveiling, particularly from banks. Meanwhile, a survey says a large majority of
CFOs don't even know about the proposal," by Tim Reason, CFO.com, April
24, 2009 ---
http://www.cfo.com/article.cfm/13561804

It's been called the most dramatic overhaul of
financial statements since the cash flow statement was introduced more than
two decades ago. But when the comment period closed last week on the ideas
for radically changing financial statements, the proposed design from the
world's accounting standard setters had been called a few other things too:
"poorly defined," "confusing," cluttered, "information overload,"
"inconsistent with management's internal reporting," and, frequently,
"costly."

In October 2008, the Financial Accounting Standards
Board and the International Accounting Standards Board jointly issued a
discussion paper laying out their preliminary ideas for changes to financial
statements that would fundamentally alter the way information is presented
on the financial statements. Comments were due last week.

The two boards said their goal was to tie the
different financial statements more closely together, provide deeper dives
into financial numbers that are often aggregated at a very high level, and
also provide a heavy emphasis on cash and liquidity. A key feature of the
proposal is that managers would separate a company's actual business
activities from its financing or funding activities. As a result, each of
the three statements — balance sheet, income statement, and cash-flow
statement — will be divided into two major sections: business and financing.

The financing section will include those activities
that fund a company's business. For nonfinancial institutions, that would
primarily include cash, bank loans, bonds, and other items that arise from
general capital-raising efforts.

The business section — which would be further
subdivided into operating and investing categories — would focus on what a
company does to produce goods and provide services. The operating category
will include primary or "core" revenue and expense-generating activities,
and the investing category will include activities that generate a return
but are not "core."

Many preparers, particularly banks, commented that
FASB and IASB needed to do more to clearly define 'operating' and
'investing' activities. "They're using the same terminology that we use in
FAS 95 for cash flows," Grant Thornton partner John Hepp told CFO.com, "But
they have completely different meanings from what they meant [in FAS 95]."
Indeed, Hepp's sentiments are echoed in Grant Thornton's official comment
letter, which notes not only that the distinction between the operating and
investing sections is "very confusing," but also that "the [discussion
paper] itself uses three different descriptions."

"I don't think FASB or IASB is real clear on what
these terms mean, so I don't know how management would apply them," Hepp
added.

Some of the debate, of course, may come down to
FASB's and IASB's desire to have management itself define what activities it
considers to be part of their company's business model for adding to
shareholder value, versus simple investment returns.

"Users of financial statements analyze how a
company creates value separately from how it funds that value creation,"
said FASB senior project manager Kim Petrone in a webcast at the beginning
of this year. "So we want to separate the creating activities from the
financing activities." Petrone explained that companies will begin by
classifying assets and liabilities based on how they are used by management.
"That management approach is going to be very important because it allows
[the accounting] to apply to many different entities. It's been asked if
this will apply to banks, and it will apply to banks."

But banks themselves were less than thrilled with
that portion of the proposal. While conceding that it might be useful for
investors of non-bank institutions to see financing activities separated
from business activities, the American Bankers Association said "this kind
of breakout will have little or no value to users of financial statements of
banking institutions. . . . In essence, both investing activities and
financing activities normally are operating activities at a bank."

"The nature of the banking industry would lead, in
our opinion, to the vast majority of activities being presented within the
business activities (operating category)," concurred the British Bankers
Association, adding that, for financial institutions, "we do not believe
that the separation of business activities from financing activities will
provide users with information that is more decision-useful than the current
presentation method."

While banks might find it impossible to distinguish
between financing and operating activities, it is interesting to think that
some of the distinctions proposed might have helped banks highlight the
difference between actual losses and the writedowns that many were forced to
take as a result of changes in fair value. Indeed, that's what at least one
analyst, not speaking specifically about the banking industry, suggested
just over a year ago. "As we see more fair value coming through the
financial statements, those statements need to do a better job of showing
where the changes are coming from; this would help a lot," Janet Pegg, a
senior managing director and an accounting analyst at Bear Stearns, told CFO
magazine in Feb 2008.

Companies
increasingly take people for a ride. They issue glossy
brochures and mount PR campaigns to tell us that they
believe in "corporate social responsibility". In
reality, too many are trying to find new ways of picking
our pockets.

Companies and
their advisers sell us the fiction of free markets. Yet
their impulse is to build cartels, fix prices, make
excessive profits and generally fleece customers. Many
continue to announce record profits. The
official UK statisticsshowed
that towards the end of 2007 the rate of return for
manufacturing firms rose to 9.7% from 8.8%. Service
companies' profitability eased to 21.2% from a record
high of 21.4%. The rate of return for North Sea oil
companies rose to 32.5% from 30.1%. Supermarkets and
energy companies have declared record profits. One can
only wonder how much of this is derived from cartels and
price fixing. The artificially higher prices also
contribute to a higher rate of inflation which hits the
poorest sections of the community particularly hard.

Cartels cannot be
operated without the active involvement of company
executives and their advisers. A key economic incentive
for cartels is profit-related executive remuneration.
Higher profits give them higher remuneration. Capitalism
does not provide any moral guidance as to how much
profit or remuneration is enough. Markets, stockbrokers
and analysts also generate pressures on companies to
constantly produce higher profits. Companies respond by
lowering wages to labour, reneging on pension
obligations, dodging taxes and cooking the books.
Markets take a short-term view and ask no questions
about the social consequences of executive greed.

The usual UK response
to price fixing is to fine companies, and many simply
treat this as another cost, which is likely to be passed
on to the customer. This will never deter them.
Governments talk about being tough on crime and causes
of crime, but they don't seem to include corporate
barons who are effectively picking peoples' pockets.

Governments need
to get tough. In addition to fines on companies, the
relevant executives need to be fined. In the first
instance, they should also be required to personally
compensate the fleeced customers. Executives
participating in cartels should automatically receive a
lifetime ban on becoming company directors. There should
be prison sentences for company directors designing and
operating cartels. That already is possible in the US.
Australia's new Labour government has recently said that
it will impose
jail termson executives
involved in cartels or price fixing. The same should
happen in the UK too. All correspondence and contracts
relating to the cartels should be publicly available so
that we can all see how corporations develop strategies
to pick our pockets and choose whether to boycott their
products and services.

The
Declaration on Strengthening the Financial System
(PDF 137k) issued by the leaders of the Group of 20
(G20) following their meeting in London on 2 April
2009 calls on the accounting standard setters to
improve standards for determining the fair values of
financial instruments in illiquid markets and to
take other actions regarding complexity of financial
reporting, provisioning, and off balance sheet
financing, among other matters:

Accounting standards
We have agreed that the accounting standard
setters should improve standards for the
valuation of financial instruments based on
their liquidity and investors' holding
horizons, while reaffirming the framework of
fair value accounting.

We also welcome the FSF
recommendations on procyclicality that
address accounting issues. We have agreed
that accounting standard setters should take
action by the end of 2009 to:

reduce the complexity of accounting
standards for financial instruments;

achieve clarity and consistency in
the application of valuation standards
internationally, working with
supervisors;

make significant progress towards a
single set of high quality global
accounting standards; and

within the framework of the
independent accounting standard setting
process, improve involvement of
stakeholders, including prudential
regulators and emerging markets, through
the IASB's constitutional review.

The IASB has responded to the G20 leaders'
recommendations and, at the same time, to
Recent Decisions
taken by the US Financial Accounting Standards Board
(FASB). Here are excerpts:

The IASB's response to the G20:
'The IASB is committed to taking action
on each of the items recommended by the
G20 by the end of 2009, the target date
suggested by the G20, in order to ensure
globally consistent and appropriate
responses to the crisis.'

The IASB's response to the FASB
actions: 'Initial reports regarding
new or additional divergences between
IFRSs and US GAAP being created by these
FSPs appear to be overstated. A
preliminary review of the FASB's
decisions by IASB staff indicates that
FASB�s objectives and approach on the
application of fair value when a market
is not active appear to be broadly
similar to those in IFRSs.'

The
Institute of Chartered Accountants of Scotland (ICAS)
says that key business information and risks to companies are obscured by the
volume and level of detail of disclosures in corporate annual reports. This
means that investors and other users of financial information have found it
harder than it should be to determine important details about listed companies
during the financial crisis. Please click through for further details.
"ICAS SAYS ANNUAL REPORTS HAVE FAILED TO TELL A CLEAR STORY DURING THE FINANCIAL
CRISIS," AccountingEducation.com, April 6, 2009 ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=149309
Jensen Comment
Scotland is part of the United Kingdom which in turn is part of the European
Union. Hence Scotland is under IFRS accounting standards with possible
exceptions adopted by the EU.

The KPMG Foundation 2008 Annual Report summarizes how much, and it has been a
lot, the KPMG Foundation has done for higher education in accounting. The two
most notable programs among various programs, at least in my thinking, have been
the minority student doctoral fellowships program and the KPMG professorships.
The KPMG Professorship program motivates alumni who work or previously worked
for KPMG to donate annually back to their alma maters to help provide those
universities with top accounting professors. The KPMG Professors in 38
universities are listed on Page 3 of the 2008 KPMG Foundation 2008 Annual
Report. This pleases me since I was, for a time, the KPMG Professor at Florida
State University.

What saddens me, however, is to note that the same Page 3 of the Report also
lists the 11 universities that have unfilled KPMG Professorships. It seems a
shame to not spend these funds for top accounting faculty since, in most cases,
these universities have accounting faculty shortages. The 11 universities are as
follows:

University of Michigan

University of Maryland

University of Iowa

University of Nebraska

University of Utah

Georgia State University

Florida State University

University of Kentucky

College of William and Mary

John Carroll University

St. Peter's College

The KPMG Foundation is also providing donations, along with the other CPA
firms, to the AICPA's new Accounting Doctoral Scholars fellowship program for
doctoral students specializing in tax and auditing, two specialties where there
are notable shortages in among the annual supply of doctoral graduates for
teaching and research.

In so many ways, CPA firms have given generously of money, time, training,
and materials to higher education accountancy programs. This has helped tie the
accounting schools/departments much closer to the profession than many other
disciplines have with their professions.

What I admire most is that the CPA firms have done this when the professors
themselves have been negligent in responding to pleas for more involvement by
accounting educators in standard setting and for research innovations of
interest to CPA practitioners (name one in financial accounting?) ---
http://www.trinity.edu/rjensen/theory01.htm#AcademicsVersusProfession

Of course the CPA firms benefit greatly from availability of highly talented
accounting graduates who have made it through rigorous filters of 30 or more
credits in accounting in our colleges. The students, in turn, benefit greatly
from internships provided by the firms and from financial support given to their
alma maters. It would be even better if the firms'
partners benefitted from academic accounting research to the extent that they
could remember two or three top academic accounting journal studies off the tops
of their heads.

This includes a link to
the Digital Collection in this library.
My reason for mentioning this is explained below.

In 1986 when Steve Zeff
was President of the AAA, I was his Program Director for the annual meetings
in the heart of Times Square (Marriott Marquis). Although NYC is always a
relatively high priced hotel city and a rather poor choice for accompanying
families with small children, NYC did have some huge advantages for me as
program director and for registrants who attended some unique sessions in
NYC.

The biggest advantage
(aside from the private showing of CATS that I've already mentioned) was
that we could get some top investment bankers from Wall Street to appear on
the program. Those particular sessions were so well attended that people
were packed into the meeting rooms like sardines. Those speakers would've
never taken the time to take a day off to fly to be in a concurrent session
of the AAA annual meetings. But they agreed to take the time off to take a
cab to Times Square to be on our program.

I suspect that there
will be similar advantages for the 2009 meetings in NYC if the AAA can
arrange for parole of some of the top Wall Street speakers. It would really
be nice to compare how the messages changed between 1986 and 2009.

I've already mentioned
that, before I retired in 2006, I captured nearly two decades of video of
sessions at accounting educator meetings, especially the American Accounting
Association annual meetings. I suspect that some of those 1986 NYC sessions
are among the 200+ videotapes that I donated to the National Library of the
Accounting Profession at the University of Mississippi.

It may be necessary to
travel to the University of Mississippi to view these tapes, but Dale
Flesher can probably arrange it so researchers can view these and other
archived presentations on my tapes. Dale has my only copies.

The National Library of
the Accounting Profession at Ole Miss has a home page at
http://www.olemiss.edu/depts/accountancy/libraries.html
This includes a link to the Digital Collection in this library, but these
are only a small percentage of the recordings available in the library.

I mention my video
tapes because in later years I taped two successive annual meeting
presentations by Denny Beresford when, as Chairman of the FASB, his
struggles to get FAS 119 and 133 launched were just getting started under a
storm of controversy. People don't realize that the SEC virtually mandated
that the FASB generate FAS 133. SEC Director told Denny that the “top three
priorities at the FASB should be Derivatives, Derivatives, and Derivatives.”

I have made audio
recordings of Denny's two successive sessions available online. Denny is not
only an articulate speaker he has a great sense of humor. One of my all time
favorite lines is when he referred to a "derivative as something a person my
age takes when prunes just quite do the job."

Issues in Teaching Computerized Accounting

My students are learning the mechanical process,
but aren't able to apply their knowledge

So we don't clutter everyone's email accounts, or
publicly praise or bash any particular author, please feel free to respond
directly to my email at markm@alextech.edu <mailto:markm@alextech.edu>
. If you have a comment relevent to the entire group,
then go ahead and reply to all.

Background:

I am teaching a two credit course where one credit
each is dedicated to QuickBooks and Peachtree. I use the same publisher for
both, but am not happy with the Peachtree textbook. The textbook is very
mechanical walking through each of the various tasks you need to learn with
lots of pictures. However, the textbook has too many errors and is so step
by step that the students don't have to think about what they are doing.
This approach is okay for the first half semester using QuickBooks, but by
the second half of the semester, they are ready for a little more
application. We have considered dropping Peachtree and spending the second
half of the semester on application case studies for QuickBooks, but at this
time, I'm looking for a better Peachtree solution.

To explain the issue a different way, I think my
students are mechanically good at QuickBooks. We finish the entire textbook
and do a fair amount of the end of chapter assignments. However, several of
my better students attempted to compete in a BPA computerized accounting
contest and failed to even get the company set up. I also had a test group
play Monopoly, and asked them to record all their transactions in
QuickBooks. It was a pretty sad day for me when I saw income statements with
the purchase of a house recorded as an expense, accumulated depreciation as
a debit with the offsetting credit to land, opening balance equity accounts
rather than capital accounts, undeposited funds on the balance sheet, and a
few other odd things.

Everyone taking this course will have completed
Principles of Accounting.

What I need:

I am looking for testimonials or advise on how some
of you have bridged the gap between textbook and application. I am curious
what textbooks you like and why. Any suggestions? Do you feel there is a
need to teach both Peachtree and QuickBooks?

Thank you for any thoughts you might have.

Mark Meuwissen
Accounting Instructor,
Alexandria Technical College

May 3, 2009 reply from Bob Jensen

Hi Mark,

The problem may be that your students are learning the computerized
accounting but not accounting. Hence garbage in, garbage out.

Some colleges avoid this by not teaching computerized accounting in order
to free up more time to learn accounting.

Other colleges provide accounting in credit courses and computerized
accounting in non-credit courses.

Other colleges require computerized accounting and accounting in three or
four basic courses rather than the typical two-course sequence of Principles
of Accounting. However, those schools often do not require as many upper
division accounting courses.

Questions
What is American Airline's estimate of the labor cost per seat per mile?
What are the accounting issues in calculating and using this number?Calculate the distance between airports ---
http://www.convertunits.com/distance/

Union Troubles at American
Airlines --- Among other things, pilots want a 50% pay increase
Unions do not seem to be swayed by the strong likelihood that AMR will declare
bankruptcy
Is American Airlines too big to fail?
Is labor counting, with a friend in the Whitehouse, on a government bailout of
American Airlines?

From The Wall Street Journal Accounting Weekly Review on April 16,
2009

SUMMARY: The
two articles cover current issues facing the airline industry.
Despite AMR Corp. facing liquidity concerns and a first-quarter
loss to be announced on Wednesday, 4/15, that is expected to
amount to about $400 million, American airlines pilots are
demanding a 50% increase in pay. The pilots gave pay concessions
in 2003 to help the company survive at that time, but now "the
2003 concessions 'are viewed by our pilots as a loan, and it's
time to restore [them],' says Sam Mayer, a pilot union spokesman
and 767 captain for American." Southwest Airlines is mentioned
in the first article; the related article focuses on its
difficulties after having entering into fuel cost hedging
transactions.

CLASSROOM
APPLICATION: The article may be used in management
accounting classes to discuss labor cost measurements, labor
negotiations, and other cost measurements unique to the airline
industry. To assess costs facing the airline industry, typical
financial statement ratios are measured in relation to passenger
miles: American's labor cost is identified as the highest of 13
biggest airlines complied by the Federal Bureau of
Transportation Statistics at $.0369 per available seat mile. The
related article also covers fuel costs and hedging activities
from a managerial accounting and financial accounting
perspective.

QUESTIONS:
1. (Introductory) What is the current state of the
airline industry, inasmuch as you can glean from this article or
your general knowledge.

2. (Introductory) Why are American Airlines pilots
negotiating for significant pay increases in their next labor
contract? How are their negotiations with corporate management
undertaken--that is, who negotiates for the pilots?

3. (Introductory) Airline employees are expressing
discontent about management pay in the last few years. How is
this issue related to turmoil in other U.S. corporations about
that issue?

4. (Advanced) How are airline costs measured? Define
the formula you think may be used for these measurements. How
does this help compare costs amongst different carriers?

5. (Advanced) Who compiles statistics about airline
operating costs? How are this entity's needs satisfied by
general purpose financial reporting and financial reporting
requirements established by the Financial Accounting Standards
Board? In your answer, define the term "general purpose
financial statements".

6. (Advanced) Refer to the related article regarding
Southwest Airline's "fuel-hedging program". How do airlines
hedge fuel costs? Be specific in describing the types of
contracts the airline will enter into and the accounting
requirements for those contracts.

7. (Advanced) What does this mean to say that the
"value" of the Southwest fuel hedging program is declining?

8. (Advanced) What actions are Southwest taking
regarding future fuel needs? What do you think that behavior
says about the company's expectations for future oil prices?

American Airlines is mired in increasingly
contentious labor negotiations with its pilots, flight attendants and
maintenance crews -- six years after union concessions allowed the carrier
to avoid bankruptcy protection.

The AMR Corp. unit faces growing liquidity concerns
as it prepares to announce Wednesday a first-quarter loss that analysts have
forecast at about $400 million. American last month said it expected to end
the quarter with a cash and short-term investment balance of approximately
$3.1 billion, down from $3.6 billion at the end of December.

Wednesday's report will be the first in a series of
what are likely to be dismal earnings announcements from U.S. airlines. Even
as the recession is gutting corporate travel budgets, workers at many
carriers, emboldened by what they see as a more labor-friendly environment
in Washington, are trying to win back wage cuts that helped the industry
survive the last downturn.

The situation is especially tense at American.
Workers at the second-largest U.S. airline by traffic agreed in 2003 to $1.8
billion in payroll cuts, pushing compensation to levels of a decade earlier.
But many of the airline's rivals -- including Delta Air Lines Inc., US
Airways Group Inc. and UAL Corp. unit United Airlines -- secured bigger cuts
in recent years through bankruptcy courts.

American's labor cost, at 3.69 cents per available
seat mile as of last September, was the highest in a list of 13 biggest
airlines compiled by the federal Bureau of Transportation Statistics.
Southwest Airlines Co. was No. 2 at 3.44 cents. Also, employee benefits,
which were cut sharply at other airlines, have remained largely intact at
American.

Nevertheless, American's pilots are demanding a 50%
pay increase. The Allied Pilots Association has rented billboards near the
Dallas-Fort Worth and Chicago O'Hare airports, slamming $300 million in
bonuses to the company's top 1,000 executives over the past three years and
highlighting an ongoing government probe into possible safety violations at
the airline.

The 2003 concessions "are viewed by our pilots as a
loan, and it's time to restore us," says Sam Mayer, a pilot-union spokesman
and 767 captain for American.

American's pilots are among the most experienced in
the industry and among the highest paid. They earned an average of about
$225,000 in salary and benefits in 2007, depending on seniority and other
factors -- well above a 15-airline average of $188,268, according to the
Massachusetts Institute of Technology.

American's management says its executive
compensation is in line with other airlines and that the airline's safety is
top-notch.

The Federal Aviation Administration is continuing
its investigation of wiring problems on American aircraft. The airline and
pilots union since last May have been in talks supervised by the National
Mediation Board. American has since entered federal mediation with
representatives of its flight attendants and maintenance crews.

Delta, the biggest U.S. airline, and Southwest
Airlines, the largest low-cost carrier, recently struck agreements for
increases well below what is sought at American. But talks are growing more
combative at US Airways, where pilots are pressing for federal mediation.
Negotiations with United's main unions are getting underway this month.

Negotiations at American could drag on for months.
Under federal labor law, airline employees are prohibited from striking
until mediators declare an impasse. If they strike, the White House can
order employees back to work, as it did 24 minutes after a pilot strike was
called at American in 1997.

Laura Glading, head of the Association of
Professional Flight Attendants, says American attendants also want to be
made whole after their salaries were cut by more than 25% six years ago. The
Transport Workers Union of America, which represents American's maintenance
crews, has called for annual pay increases of 6%, 4% and 3%, respectively,
over the next three years. Transport workers plan to shred and burn mock
executive pay checks at American's headquarters in Fort Worth on Tuesday.

American has yet to make wage counterproposals to
the pilots' union or flight attendants, preferring to first work on
productivity issues. The airline's most recent offer to transport workers
included a 5% bonus payment in return for scaled-back medical benefits.
American also said last week that it will freeze wages for nonunion
employees, which represent about a quarter of the airline's U.S. work force.

Analysts say big pay increases at American could
push the airline to the brink of insolvency.

American executives are making the same argument as
they urge unions to scale back demands. "If we don't exist, they don't
exist," says Jeffrey Brundage, American's senior vice president for human
resources.

Fitch Ratings slashed the airline's credit rating
last month to triple-C, pushing the rating deeper into speculative, or junk,
territory.

The deadlock with pilots already has stalled
American's plan to fly planes to Beijing from Dallas, which is subject to
the pilots' approval because it involves long-distance flights. Unions also
could step up opposition to possible job cuts from a proposed trans-Atlantic
alliance between American and British Airways PLC that is receiving
antitrust scrutiny. Unions hope their leverage will improve since President
Barack Obama nominated Linda Puchala, a former flight-attendant-union
official, last month to run the National Mediation Board. Ms. Puchala awaits
Senate confirmation and didn't respond to requests for an interview.

The current chairman, Read Van de Water, was a
former lobbyist for Northwest Airlines Corp. The board has been neutral in
all its work, she says, and has been equally strict with companies and
unions. Ms. Van de Water says negotiations between American and its pilots
have been "very, very tough" and that both sides remain far apart.

Jensen Comment
There are huge problems in computing the labor cost per seat per mile for
American Airlines. First of all there's the problem of defining "labor" cost.
Secondly, there are joint costs of providing services such as cargo and mail
hauling versus passenger hauling. Any joint cost allocation formula is
arbitrary. Thirdly, many airline labor costs such as maintenance labor costs and
pilot costs and passenger agent costs are fixed or semi-fixed such that adding
or eliminating flights does not correlate very well with changes in labor costs.

The Modigliani-Miller theorem (of Franco
Modigliani, Merton Miller) forms the basis for modern thinking on capital
structure. The basic theorem states that, in the absence of taxes,
bankruptcy costs, and asymmetric information, and in an efficient market,
the value of a firm is unaffected by how that firm is financed.[1] It does
not matter if the firm's capital is raised by issuing stock or selling debt.
It does not matter what the firm's dividend policy is. Therefore, the
Modigliani-Miller theorem is also often called the capital structure
irrelevance principle.

Modigliani was awarded the 1985 Nobel Prize in
Economics for this and other contributions.

Miller was awarded the 1990 Nobel Prize in
Economics, along with Harry Markowitz and William Sharpe, for their "work in
the theory of financial economics," with Miller specifically cited for
"fundamental contributions to the theory of corporate finance."

The late Nobel laureate Merton Miller and I,
although good friends, long debated whether this kind of capital-structure
management is an essential job of corporate leaders. Miller believed that
capital structure was not important in valuing a company's securities or the
risk of investing in them. My belief -- first stated 40 years ago in a graduate
thesis and later confirmed by experience -- is that capital structure
significantly affects both value and risk. The optimal capital structure evolves
constantly, and successful corporate leaders must constantly consider six
factors -- the company and its management, industry dynamics, the state of
capital markets, the economy, government regulation and social trends. When
these six factors indicate rising business risk, even a dollar of debt may be
too much for some companies. Michael
Milken, "Why Capital Structure Matters Companies that repurchased stock
two years ago are in a world of hurt," The Wall Street Journal, April 21,
2009 ---
http://online.wsj.com/article/SB124027187331937083.html

Thirty-five years ago business publications were
writing that major money-center banks would fail, and quoted investors who
said, "I'll never own a stock again!" Meanwhile, some state and local
governments as well as utilities seemed on the brink of collapse. Corporate
debt often sold for pennies on the dollar while profitable, growing
companies were starved for capital.

If that all sounds familiar today, it's worth
remembering that 1974 was also a turning point. With financial institutions
weakened by the recession, public and private markets began displacing banks
as the source of most corporate financing. Bonds rallied strongly in
1975-76, providing underpinning for the stock market, which rose 75%. Some
high-yield funds achieved unleveraged, two-year rates of return approaching
100%.

The accessibility of capital markets has grown
continuously since 1974. Businesses are not as dependent on banks, which now
own less than a third of the loans they originate. In the first quarter of
2009, many corporations took advantage of low absolute levels of interest
rates to raise $840 billion in the global bond market. That's 100% more than
in the first quarter of 2008, and is a typical increase at this stage of a
market cycle. Just as in the 1974 recession, investment-grade companies have
started to reliquify. Once that happens, the market begins to open for
lower-rated bonds. Thus BB- and B-rated corporations are now raising capital
through new issues of equity, debt and convertibles.

This cyclical process today appears to be where it
was in early 1975, when balance sheets began to improve and corporations
with strong capital structures started acquiring others. In a single recent
week, Roche raised more than $40 billion in the public markets to help
finance its merger with Genentech. Other companies such as Altria, HCA,
Staples and Dole Foods, have used bond proceeds to pay off short-term bank
debt, strengthening their balance sheets and helping restore bank liquidity.
These new corporate bond issues have provided investors with positive
returns this year even as other asset groups declined.

The late Nobel laureate Merton Miller and I,
although good friends, long debated whether this kind of capital-structure
management is an essential job of corporate leaders. Miller believed that
capital structure was not important in valuing a company's securities or the
risk of investing in them.

My belief -- first stated 40 years ago in a
graduate thesis and later confirmed by experience -- is that capital
structure significantly affects both value and risk. The optimal capital
structure evolves constantly, and successful corporate leaders must
constantly consider six factors -- the company and its management, industry
dynamics, the state of capital markets, the economy, government regulation
and social trends. When these six factors indicate rising business risk,
even a dollar of debt may be too much for some companies.

Over the past four decades, many companies have
struggled with the wrong capital structures. During cycles of credit
expansion, companies have often failed to build enough liquidity to survive
the inevitable contractions. Especially vulnerable are enterprises with
unpredictable revenue streams that end up with too much debt during business
slowdowns. It happened 40 years ago, it happened 20 years ago, and it's
happening again.

Overleveraging in many industries -- especially
airlines, aerospace and technology -- started in the late 1960s. As the
perceived risk of investing in such businesses grew in the 1970s, the price
at which their debt securities traded fell sharply. But by using the capital
markets to deleverage -- by paying off these securities at lower, discounted
prices through tax-free exchanges of equity for debt, debt for debt, assets
for debt and cash for debt -- most companies avoided default and saved jobs.
(Congress later imposed a tax on the difference between the tax basis of the
debt and the discounted price at which it was retired.)

Issuing new equity can of course depress a stock's
value in two ways: It increases the supply, thus lowering the price; and it
"signals" that management thinks the stock price is high relative to its
true value. Conversely, a company that repurchases some of its own stock
signals an undervalued stock. Buying stock back, the theory goes, will
reduce the supply and increase the price. Dozens of finance students have
earned Ph.D.s by describing such signaling dynamics. But history has shown
that both theories about lowering and raising stock prices are wrong with
regard to deleveraging by companies that are seen as credit risks.

Two recent examples are Alcoa and Johnson Controls
each of which saw its stock price increase sharply after a new equity issue
last month. This has happened repeatedly over the past 40 years. When a
company uses the proceeds from issuance of stock or an equity-linked
security to deleverage by paying off debt, the perception of credit risk
declines, and the stock price generally rises.

The decision to increase or decrease leverage
depends on market conditions and investors' receptivity to debt. The period
from the late-1970s to the mid-1980s generally favored debt financing. Then,
in the late '80s, equity market values rose above the replacement costs of
such balance-sheet assets as plants and equipment for the first time in 15
years. It was a signal to deleverage.

In this decade, many companies, financial
institutions and governments again started to overleverage, a concern we
noted in several Milken Institute forums. Along with others, including the
U.S. Chamber of Commerce, we also pointed out that when companies reduce
fixed obligations through asset exchanges, any tax on the discount
ultimately costs jobs. Congress responded in the recent stimulus bill by
deferring the tax for five years and spreading the liability over an
additional five years. As a result, companies have already moved to
repurchase or exchange more than $100 billion in debt to strengthen their
balance sheets. That has helped save jobs.

The new law is also helpful for companies that made
the mistake of buying back their stock with new debt or cash in the years
before the market's recent fall. These purchases peaked at more than $700
billion in 2007 near the market top -- and in many cases, the value of the
repurchased stock has dropped by more than half and has led to ratings
downgrades. Particularly hard hit were some of the world's largest companies
(i.e., General Electric, AIG, Merrill Lynch); financial institutions
(Hartford Financial, Lincoln National, Washington Mutual); retailers
(Macy's, Home Depot); media companies (CBS, Gannett); and industrial
manufacturers (Eastman Kodak, Motorola, Xerox).

Without stock buybacks, many such companies would
have little debt and would have greater flexibility during this period of
increased credit constraints. In other words, their current financial
problems are self-imposed. Instead of entering the recession with adequate
liquidity and less debt with long maturities, they had the wrong capital
structure for the time.

The current recession started in real estate, just
as in 1974. Back then, many real-estate investment trusts lost as much as
90% of their value in less than a year because they were too highly
leveraged and too dependent on commercial paper at a time when interest
rates were doubling. This time around it was a combination of excessive
leverage in real-estate-related financial instruments, a serious lowering of
underwriting standards, and ratings that bore little relationship to
reality. The experience of both periods highlights two fallacies that seem
to recur in 20-year cycles: that any loan to real estate is a good loan, and
that property values always rise. Fact: Over the past 120 years, home prices
have declined about 40% of the time.

History isn't a sine wave of endlessly repeated
patterns. It's more like a helix that brings similar events around in a
different orbit. But what we see today does echo the 1970s, as companies use
the capital markets to push out debt maturities and pay off loans. That
gives them breathing room and provides hope that history will repeat itself
in a strong economic recovery.

It doesn't matter whether a company is big or
small. Capital structure matters. It always has and always will.

The late Nobel laureate Merton Miller and I,
although good friends, long debated whether this kind of
capital-structure management is an essential job of corporate leaders.
Miller believed that capital structure was not important in valuing a
company's securities or the risk of investing in them. My belief --
first stated 40 years ago in a graduate thesis and later confirmed by
experience -- is that capital structure significantly affects both value
and risk. The optimal capital structure evolves constantly, and
successful corporate leaders must constantly consider six factors -- the
company and its management, industry dynamics, the state of capital
markets, the economy, government regulation and social trends. When
these six factors indicate rising business risk, even a dollar of debt
may be too much for some companies.

Bob, is the above passage your statement? If so,
AECMers will no doubt be alarmed to hear that once again I agree with you.
Oh, I don't agree to the extent that I've been teaching it 40 years (after
all, you are older than I), but I have been teaching it for ten years or so.

When I teach the right side of the balance sheet,
as well as the non-operating part of the income statement), I run students
through a review of capital structure. The right hand side of the balance
sheet starts with current liabilities (20-30% of assets on average), then
the remaining 70-80% is split between long-term liabilities and common
equity. It is easy to see the industry risk effect on the relative
composition of this large remainder. Companies that are inherently risky due
to being built on easy to disappear intellectual property have very little
in the way long-term liabilities. Examples are Internet/software companies
like Google or Microsoft, and pharmaceuticals like Merck. Companies that are
mostly riskless due to permanence of their assets can bear much in the way
of long-term liabilities. I used to cite commercial banks as an example,
because the legal system and federal guarantees protects some of the
liabilities.

I for one champion the move to value liabilities at
fair value, as it can be a useful benchmark for analysts to judge the
relative proportion of debt to equity in the capital structure.

However, there is a lot of criticism of fair value
applied to the right side of the balance sheet. I've received a handful of
comments that oppose right-hand side fair valuation in severe downturns just
like we have experienced. Because bank assets take a hit, the survivability
of the bank is at question. This means that if a higher or riskier interest
rate were applied to value right-hand side liabilities, there would be a
gain that could swamp the losses from the asset side. There are some that
don't like a company reporting a neutral income statement when the company
is going down the tubes. Consequently, they call for scaling back the fair
value rule to the asset side only.

David Albrecht

April 22, 2009 reply from Bob Jensen

Hi David,

That passage was written by Mike Milken, which is why I had it in italics
and a different color.

I don’t think Milken was thinking about accounting rules when he wrote
this article. He probably was thinking more in terms of held-to-maturity
debt under FAS 115 rules where HTM debt is not marked-to-market with
changing capital structure levels that are actually hypothetical.

The problem with fair value adjustments of long term debt is that these
adjustments are poorly correlated with cash flows and can change capital
structure in misleading ways for firms not intending to buy back debt. There
are many reasons firms will not buy back debt even when there are gains to
be realized from declines in interest rates. One of the big barriers is the
transaction cost of buying back debt which makes it take a pretty large drop
in interest rates to make buy-backs worthwhile.

Another factor is that debt holders often will not sell unless forced to
do so in call back clauses of debt contracts, but the call back penalties
may be very high and add to the transactions costs. For this reason debt is
commonly classified as HTM and not adjusted to fair value.

Another reason firms do not commonly buy back debt is that FAS 125 ended
the practice of in-substance defeasance for getting around call back fees
and transactions costs for live debt that was being removed, before FAS 125,
with defeasance accounting.

In-substance defeasance used to be a ploy to take debt off the balance
sheet. It was invented by Exxon in 1982 as a means of capturing the millions
in a gain on debt (bonds) that had gone up significantly in value due to
rising interest rates. The debt itself was permanently "parked" with an
independent trustee as if it had been cancelled by risk free government
bonds also placed with the trustee in a manner that the risk free assets
would be sufficient to pay off the parked debt at maturity. The defeased
(parked) $515 million in debt was taken off of Exxon's balance sheet and the
$132 million gain of the debt was booked into current earnings ---
http://www.bsu.edu/majb/resource/pdf/vol04num2.pdf

Defeasance was thus looked upon as an alternative to outright
extinguishment of debt until the FASB passed FAS 125 that ended the ability
of companies to use in-substance defeasance to remove debt from the balance
sheet. Prior to FAS 125, defeasance became enormously popular as an OBSF
ploy.

The bottom line is that I think long-term debt should not be adjusted for
fair value although fair value trends should be disclosed in footnotes.

As with CAPM, the MM assumptions are unrealistic. However, much empirical
evidence (of the accountics variety) points to evidence that the MM theory
is relatively robust. However, this empirical support also makes limiting
assumptions in testing models that test the MM theory. The MM theorem has
been used over and over again in practice to justify adding leverage.

Two universities--Kean University in Union, NJ and
Emory University in Atlanta, GA--have gone public with their use of
Datawatch's Monarch data mining software to teach students how to perform
business intelligence work.

Kean professor Beth Brilliant introduced Monarch to
graduate students of her accounting information systems (AIS) and auditing
information system classes.

"I have been using Monarch for years as a
[certified public accountant] and swear by it," said Brilliant. "For
example, I use Monarch to quickly find any bank discrepancies. As I work for
a law firm with client trust accounts, this is extremely important, as all
accounts must balance to the penny. I am able to reconcile all the accounts
in minutes thanks to Monarch, picking up differences in checks from pennies
to hundreds of thousands of dollars."

Brilliant added, "My department has also become
more efficient with the use of Monarch, saving hours by importing data into
the accounting system electronically vs. manually. Reports that I receive
from vendors are saved as PDF files, which are mined using Monarch. The data
is then extracted and imported into our accounting system. This not only
saves time but it removes the risk of manual data input errors."

"I rely on Monarch to ensure data quality and to
ensure I know exactly where company data is coming from, with no need to
rely on the company's accounting and IT departments," she explained.
"Monarch is an excellent resource for auditors and accountants, and well
worth including Monarch within my AIS coursework."

Robert Gross teaches a graduate course on managing
healthcare databases at the Rollins School of Public Health at Emory. The
course is part of the curriculum for the university's master of public
health degree.

"Most of my students are physicians and other
working healthcare providers, middle managers and public health agency
leaders," said Gross. "The students are non-technical, yet must understand
how to independently gather, sift, sort, and work effectively with public
and private healthcare information sources. We address issues including
effective data access strategies, how to ensure data quality, comply fully
with HIPAA, and actively work with healthcare data using Excel, Access, and
several statistical analysis products."

Have you ever asked yourself, "Why do we even do audits?" Most CPAs will
say, "Because they are required?" But why are audits required? Audited
financial statements are valuable because they reduce the client's cost of
capital. How? Because audited statements reduce the user's assessed risk.
Assume a bank has a loan request from two companies, identical in every
respect, except that one has audited statements and the other doesn't. All
things being equal, the bank will charge a lower rate of interest, and maybe
impose fewer or less onerous covenants, to the company with audited
statements.

So where does audited financial
statement value come from? There are two sources. The first
source is that the numbers are fairly presented, not materially
misstated. To most users fairly presented means the numbers are
'right' or 'accurate.' The second source of value is that users
believe the numbers are right. Even if the financial statements
have a 'clean' opinion, if the user, bank loan officer, donor,
vendor, customer, taxpayer, doesn't believe it, the statements
have no value.

So how do you create
'believability' value? We all know that the second general
standard in SAS No. 1 requires auditors to be independent. To be
qualified to issue an opinion you must be independent. If you're
not independent you have disqualified yourself from issuing and
opinion, even if the numbers are 'right.' Here are four
requirements in SAS No. 1 that you must comply with to qualify
to issue an opinion:

For dependability of his
findings, auditors must be without bias — not a prosecutor
but should have judicial impartiality and an obligation for
fairness on those who rely on it.

To be independent, an
auditor must be intellectually honest.

Auditors should avoid
situations that may lead outsiders to doubt their
independence.

Our code of conduct has
precepts to guard against presumption of loss of
independence.

Unfortunately, there are a
whole host of structural defects and behaviors that make if
nearly impossible to comply with the independence requirement.

Auditors must be without
bias

The first problem is that our
profession's model is fundamentally flawed. Who pays for the
work? The client. What's the flaw? No one can be truly
independent of someone who pays for the work.

Think about this: Would it be
a good idea for restaurant inspectors, building inspectors,
power plant inspectors, OHSA inspectors, FDIC inspectors, or
meat packing plant inspectors to be paid by the companies they
inspect? Why not? Because doing this would impair their judgment
and independence.

Why don't we have the
restaurants pay for the inspections, but have a code of
professional conduct requiring the inspectors to be independent?
Because we all know such a system would not work. So how are
auditors independent when they are paid by the client? That's
the system we're stuck with. So until the profession develops
another payment mechanism, our independence will always be
suspect. No amount of rules or punishment is as powerful a
motivator as getting paid. If people followed the rules, no one
would cook the books, and Arthur Andersen would still be around.

An auditor must be
intellectually honest

Are you an ethical CPA? "Of
course," you say to yourself. But have you ever had a client who
treats the company (could be a private or public company,
government, or non-profit entity) as his or her own personal
piggy bank? Yep. If you knowingly let your client take a clearly
personal expense through the entity, it's a violation of SAS No.
1. Why? Because you've knowingly allowed your client to violate
his or her own internal controls. Please explain how it's
intellectually honest to knowingly let a client violate internal
controls to take an illegal tax deduction.

Furthermore, paragraph 10 of
SAS 107, "Audit Risk and Materiality in Conducting an Audit" in
part states: "When the auditor encounters evidence of potential
fraud, regardless of its materiality, the auditor should
consider the implications for the integrity of management or
employees and the possible effect on other aspects of the
audit."

Just because the deduction is
immaterial for financial reporting does not mean it's legally
OK. In other words, legality and materiality are two different
things. How can auditors render a clean opinion knowing the
financial statements are misstated by an illegal amount? It's
willful because you see the deduction and do nothing about it,
for example, by putting the illegal deductions on your" passed
adjustments" list. Doesn't "willful blindness" of illegal
activities by its nature render the auditor not independent? In
other words, if an auditor is truly independent, he or she would
stand up to the client and force proper accounting. Issue a
1099, repay the money and set up a receivable. Do anything for
proper accounting.

Avoid situations that
may lead outsiders to doubt their independence

SAS 107 defines materiality as
"the magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances,
makes it probable that the judgment of a reasonable person
relying on the information would have been changed or influenced
by the omission or misstatement." Note that there is no
percentage or amount in the definition.

Thus, if users would make a
different decision, then the amount/transaction/event are
material. Note the definition says "reasonable person." It does
not say "reasonable accountant or reasonable auditor." Who are
these "reasonable persons?" Think bank loan officer, nonprofit
donor, taxpayer, regulator, or newspaper reporter. If you were
required to disclose every personal expense taken as a corporate
deduction in the opinion, would you allow them? If not, on what
basis is it to look the other way now?

Furthermore, paragraph
14 of SAS 107 and Policy 2 of Statement on Quality Control
Standards No. 7, Establishing and Maintaining a System of
Quality Control for a Firm's Accounting and Auditing Practice,
both require the firm to have the expertise necessary to
properly perform the engagement. If you don't have the
expertise, you're not independent. For example,
Bernard Madoffhas admitted to a
$50 billion Ponzi scheme. The auditor was a three-person firm?
Thus, the situation rendered the firm unqualified to issue an
opinion.

Guard against presumption
of loss of independence

I can't tell you how many
times I've had people in class say, "If we didn't let clients
run small personal expenses through the company, we wouldn't
have any clients." My reply is, "In other words, if you don't
let your clients cheat on their income tax returns, you wouldn't
have an accounting firm?"

Think about this, if you
aren't willing to walk away, lose the client, and refuse to let
a client cheat on the tax return, even if completely
insignificant, how can you sign the opinion saying you're
independent? Using this standard, are you or your partners or is
your firm independent? It's a scary thought for the reliability
of financial statements.

So what might be a
solution?

The only real solution is to
structure a system where the client does not pay for the audit.
But the system will change only after there is another round of
audit failures. And we find, again, that the current system does
not work, and Congress mandates change in how audits are paid
for (those options require another article).

Because of recent scandals
about the reliability of drug testing, medical journal
publishers have instituted strict disclosure of financial
interests or other conflicts between scientists testing the
drugs and the pharmaceutical manufacturers.

Do you think full and fair
disclosure of drug testing conflicts is a good idea so that
users, doctors, hospitals, the public, have independent test
results? If so, why don't the AICPA and SEC require firms
disclose in the opinion that the client paid for the audit? If
we are so confident of our independence, why do we hide our
relationship?

Will you do the right
thing?

I know much of this conflicts
with what has for some firms become acceptable practice. It's no
different than breaking the law when you speed when driving. You
rationalize your behavior. "I'm just keeping up with traffic.
There aren't many cops around. I'm a really good driver. If I
drive the speed limit I'll get run over." All those may be true.
But it doesn't make speeding legal. And just because many
clients do it doesn't make it legal.

It's that simple. You won't
like this: If you have clients that will leave if you don't
allow past behaviors, which puts the firm at risk? Whose fault
is that?

What's the solution? Simply
comply with our profession's requirement to be independent. If
you don't, you've disqualified yourself from rendering an
opinion, even if the numbers are right.

About the author
Gary D. Zeune, CPA, is a nationally recognized speaker and
writer on fraud and auditing, and founder of
The Pros & The Cons, the nation's only speakers' bureau
for white-collar criminals. He teaches fraud classes for the FBI
and numerous professional associations, and is the author of
The CEO's Complete Guide to Committing Fraud and Outside the Box
Performance. Contact Gary at
gzfraud@bigfoot.com or 614-761-8911

Any action from G20 leaders who have focused on tax
havens and are promising reforms would be welcomed, as many countries are
losing tax revenues that could be used to improve social infrastructure.
However, none have made any commitment to force companies to explain how
their profits are inflated by tax avoidance schemes. This has serious
consequences for managing the domestic economy and equity between corporate
stakeholders.

Tax avoidance has created a mirage of large
corporate profits, which has turned many a CEO into a media star and even
secured knighthoods and peerages for some. Yet the profits have been
manufactured by a sleight of hand. Let us get back to the basics. To
generate wealth, at the very least, three kinds of capital need to be
invested. Shareholders invest finance capital and expect to receive a
return. Markets exert pressure for this to be maximised. Employees invest
human capital and expect to receive a return in the shape of wages and
salaries. Society invests social capital (health, education, family,
security, legal system) and expects a return in the shape of taxes. Over the
years, corporate tax rates have been reduced, but the return on social
capital is under constant attack by tax avoidance schemes. The aim is to
transfer the return accruing to society to shareholders. Companies have
reported higher profits, not because they undertook higher economic activity
or produced more desirable goods and services, but simply by expropriating
the returns due to society. This can only be maintained as long as
governments and civil society remain docile.

Companies engaging in tax avoidance schemes publish
higher profits but do not explain the impact of tax avoidance schemes on
these profits. Consequently, markets cannot make assessment of the quality
of their earnings, ie how much of the profit is due to production of goods
and services and thus sustainable, and how much is due to expropriation of
wealth from society. In the absence of such information, markets cannot make
a rational assessment of future cashflows accruing to shareholders.
Inevitably, market assessment of risk is mispriced and resources are
misallocated. By concealing tax avoidance schemes, companies have
deliberately provided misleading information to markets. The subsequent
imposition of penalties for tax avoidance, if any, will reduce future
company profits. But the cost will be borne by the then shareholders rather
than by the earlier shareholders who benefited from the tax scams. Thus the
secrecy surrounding tax avoidance schemes causes involuntary wealth
transfers and must also undermine confidence in corporations because they
are not willing to come clean.

Governments collect data on corporate profits to
gauge the health of the economy and develop economic policies. However, this
barometer is misleading too because it does not distinguish between normal
commercial sustainable profits and profits inflated by tax avoidance.

Company executives are major beneficiaries of tax
avoidance because their remuneration is frequently linked to reported
profits. They can increase these through production of goods and services,
but many have deliberately chosen to raid the taxes accruing to society.
Company executives could provide honest information and explain how much of
their remuneration is derived from the use of tax avoidance schemes, but
none have done so. As a result, no shareholder or regulator can make an
objective assessment of company performance, executive performance or
remuneration. By the time the taxman catches up with the company and imposes
fines and penalties, many an executive has moved on to newer pastures and is
not required to return remuneration to meet any portion of those penalties.
Seemingly, there are no penalties for artificially inflating executive
remuneration.

Under the UK Companies Act 2006, company directors
have a duty to avoid conflicts of interests. They are required to promote
the success of the company for the benefit of its members, which is taken to
mean "long-term increase in value" and must also publish "true and fair"
accounts. It is difficult to see how such obligations can be discharged by
systematic misleading of markets, shareholders, governments and taxpayers.
Hopefully, stakeholders will bring test cases.

Jensen Comment
For years I've maintained a Timeline on derivative financial instruments fraud
and the evolution of FAS 133, FIN 141(R), and IAS 39 provisions to steadily
improve the accounting for such instruments. At the same time, however, the
Federal Reserve under Alan Greenspan and the SEC under various inept directors
allowed investment banks to conduct frauds year after year in unregulated
markets, albeit that many of the transactions were not fraudulent. However, many
were highly fraudulent even in the most prestigious investment banks and
brokerage firms like Merrill Lynch that, among other frauds, bilked Orange
County of over a billion dollars.

My hero has been Frank Partnoy who was for a short time one of the bad guys
selling dubious derivatives. Frank had a conscience and since the early 1990s
wrote whistle blowing books that, while entertaining, did not persuade policy
makers like Alan Greenspan and Arthur Levitt to regulate the wild west
derivatives market.

Third,
financial derivatives were now everywhere --- and largely
unregulated. Increasingly, parties were using financial
engineering to take advantage of the differences in legal rules
among jurisdictions, or to take new risks in new markets. In
1994, The Economist magazine noted, "Some financial
innovation is driven by wealthy firms and individuals seeking
ways of escaping from the regulatory machinery that governs
established financial markets." With such innovation, the
regulators' grip on financial markets loosened during the
mid-to-late 1990s . . . After Long-Term Capital (Management)
collapsed, even Alan Greenspan admitted that financial markets
had been close to the brink.

As 1987
began, Andy Krieger (at
Salomon Brothers and doing currency trading through
Bankers Trust)found what
he believed was an incredible opportunity to make money trading
currency options The U.S. Federal Reserve and various central
banks in Europe had implemented policies to maintain their
currencies within a stable zone. The dollar had been falling for
several years, but during 1987 it stabilized, and by the fall of
1987 the volatility numbers traders were using to evaluate
currency options were very low. As a result, currency options
were incredibly cheap . . . If these (currency trading banks)
had been buying and selling stocks instead of currencies, such
efforts to move short-term prices would have constituted "market
manipulation." But currency markets were unregulated
free-for-all, where manipulative trading tactics were quite
common and perfectly legal. By manipulating prices, a trader
might be able to generate profits even if the markets were quite
efficient. This was something academics studying financial
markets hadn't yet considered. And it was something the traders
loved to do.

Manipulative practices were especially common in the
over-the-counter markets --- the wild Wild West of trading.
Instead of buying and selling options on a centralized exchange,
which acted as a counterparty to all trades, traders could enter
into private contracts with buyers and selliers, typically other
banks . . . The exchanges monitored manipulative practices but
nobody watched the over-the-counter traders.

In one infamous episode, Krieger sold, or shorted,
roughly the entire money supply of New Zealand. He also held call options --- of similar
amounts --- which benevit if the kiwi went up, and therefore
woudl offset any losses from his short position . . . Krieger's
stragegy drew from one of the central insights of modern
finance, generally known as parity (or put-call parity),
and it is worth taking a few minutes to contemplate ---
http://en.wikipedia.org/wiki/Put-call_parity

. . .

Currency-options traders were shocked, and trading currency
options nearly halted for a few hours before Krieger resigned.
Again, rumors swirled about Krieger's resignation, including
word that Banker Trust had incurred huge losses in currency
options, perhas as mch as $100 million. A spokesman denied the
rumors, the the denial only fed speculation about what had
happened at Bankers Trust.

There are two sides to derivatives -- one positive
and beneficial, one exploitive and negative. Of the latter, the most visible
example today comes to us courtesy of the American International Group (AIG)
and reveals what happens when a lightly regulated but highly interconnected
financial institution ends up positioned in a way that it cannot survive a
housing crash and then such a crash occurs.

The other side of derivatives, however, involves
the less-publicized but widespread use of these financial instruments in
ways that benefit companies. Derivatives have been immensely valuable tools
and will be instrumental in providing the liquidity needed to jump-start the
economy. Derivatives are used by a vast number of U.S. companies, both small
and large, to manage various risks that arise in connection with their
businesses.

From the perspective of Main Street companies,
derivatives are not just about high finance, quants and politics, but about
investing in America's core industries, jobs and economic recovery.
Companies find that over-the-counter derivatives are essential to their
day-to-day operations. Derivatives help insulate them from risk, which
allows them to borrow capital at better prices than they would otherwise.
And derivatives are more useful than ever in these days of unusual
volatility in financial markets.

For example, not being able to hedge currency risk
through the use of a derivative can leave a company exposed to fluctuations
in currency markets. Without derivatives companies could see movements in
exchange rates turn a profitable export contract into a money-losing
agreement.

For those unfamiliar with market jargon, credit
default swaps, which are most often in the news, are simply financial
contracts between two parties. If, for example, you own bonds in a company
and are worried that the company will default, you can manage your risk and
protect your holdings with a credit default swap. Under it, you would make
regular payments to maintain the contract. If the company does not default,
you're out-of-pocket the payments. But if the company does default, the swap
serves as a form of insurance by giving you the right to exchange the
questionable bonds for the principal amount, or to be reimbursed in other
ways. There's nothing exotic or complex about these contracts. They can be
highly valuable for Main Street firms, because they enable them to protect
themselves against the failure of large customers.

However, Main Street firms cannot afford
derivatives unless there is a competitive market for them with participants
willing to take the opposite position. Restricting access to derivative
markets, which is being proposed by some in Congress as well as by some
regulators, would make the costs of derivatives prohibitively expensive and
eliminate liquidity.

That derivatives benefit our financial system and
our national economy is well established. Twenty-nine of the 30 companies
that make up the Dow Jones Industrial Average use derivatives. According to
data from Greenwich Associates, two-thirds of large companies (those that
have sales of more than $2 billion) use over-the-counter derivatives and
more than half of all mid-size companies (those that have sales between $500
million and $2 billion) are very active in derivatives markets. Derivatives
are necessary and helpful tools for companies seeking to manage financial
risk.

The most important benefit of derivatives is that
they allow businesses to hedge risks that otherwise could not be hedged.
This does a number of positive things. It transfers risk, allowing firms to
guard against being forced into financial distress. It also frees lenders to
offer credit on better terms, giving companies access to funds that they can
use to keep their doors open, lights on and, even, invest in new
technologies, build new plants, or hire new employees.

It's important for regulators not to overreact by
pushing for counterproductive new rules. The regulators, after all, were no
better at foreseeing the current crisis than the private sector, proving
that regulation has obvious limits and cannot replace efforts by financial
institutions to devise risk-management approaches that enable them to cope
with crises in the financial markets of the 21st century.

At the same time, some sensible regulations are in
order. With the interconnectedness of markets today and the systemic
problems facing the world's economies, there is a lot that can be done to
limit systemic risks. One beneficial step would be for Congress to adopt
some version of a systemic-risk regulator that would place every participant
in the financial markets that poses a systemic risk, including derivatives
traders, under federal regulatory oversight.

Unbelievably, the arm of AIG that dealt with
derivative products was not subject to serious scrutiny by a federal agency
with relevant experience. A systemic-risk regulator, or markets-stability
regulator, should oversee every kind of financial institution that is found
to be systemically important, including banks, broker-dealers, insurance
companies, hedge funds, private equity funds and others. That regulator
should have the authority to ensure that such financial institutions have
sufficient capital to reduce the risks they pose to the financial system, to
examine parent companies and subsidiaries, and to bring enforcement actions.

Additionally, a clearinghouse for standardized
credit default swaps was launched in March, and other competitor
clearinghouses are under construction. Clearinghouses clear and settle
trades and limit the risk to the larger financial system if any one dealer,
like AIG, fails to meet its obligations. A clearinghouse also allows
regulators to monitor the exposure firms have to these products, while
simultaneously ensuring that each firm posts the necessary collateral to
cover its obligations under its trades.

However, clearinghouses should be reserved for
established and standardized derivatives, leaving participants in capital
markets free to engage in bilateral contracts for derivatives that fulfill
specific needs as well as for new products. Further, use of a clearinghouse
should not be compulsory, but capital-requirement regulations should
recognize that derivatives positions that are not put through a
clearinghouse may pose greater systemic risks than those that are.

The subprime mess triggered one of the most
destructive financial crises in decades. It's not surprising, then, that the
hunt is on for culprits. But derivatives are not the culprit. They had
little to do with the rise and collapse of housing prices. Wider
availability of housing derivatives would have actually reduced the impact
of the collapse of housing prices if homeowners had been able to hedge
against possible decreases in home values.

Our businesses need derivatives. Most of us choose
to drive cars even though they sometimes crash. But we also insist that cars
are made as safe as it makes economic sense for them to be, and that speed
limits and other rules of the road are enforced. The same logic should apply
to derivatives.

Dr. Stulz is a professor of finance at the Fisher College of The Ohio
State University.

From The Wall Street Journal Accounting Weekly Review on April 23,
2009

SUMMARY: "René
Stulz makes an excellent case why the responsible use of derivatives
can help bona fide users, and ultimately help Main Street," writes
this New York resident to the WSJ Opinion page editors. However, Mr.
Hope of Pacific Palisades, CA, recalls in his letter a time when, as
a "young, inexperienced chief financial officer of a Fortune 500
company," he decided against "investing" in interest rate swaps
"pitched" by "a prominent investment banking firm." Professor
Stulz's related letter was published on the opinion page on April 7.

CLASSROOM APPLICATION: Accounting
students studying derivatives should realize the economic and
finance issues behind these contracts in addition to understanding
the accounting requirements and being able to execute entries for
them. The letter describing how a CFO raised questions about
transactions new to him at the time provides a helpful perspective
as well.

QUESTIONS:
1. (Introductory)
Refer to the related article by Professor René Stulz of the Finance
Department at the Ohio State University's Fisher College of
Business. In it, he cites the financial statement disclosure by
Caterpillar, Inc., regarding the risks it hedges by using
derivatives. List these risks and state the derivatives used to
hedge against those risks.

2. (Advanced)
Why must there be a market behind derivatives in order for them to
be executed? In your answer, comment on the difference between
standardized derivatives traded via a clearinghouse and
individualized derivative contracts.

3. (Advanced)
What derivatives did Mr. Hope consider using as a "young,
inexperienced CFO at a Fortune 500 company"? What risks were those
derivatives designed to hedge? In your answer, explain how that
hedging contract could benefit his company. Also, explain what
economic factors likely led to the fact that a strategy of not using
derivatives "worked out fine" for his company. (Hint: consider what
happened to interest rates during the 1980s.)

4. (Introductory)
What questions did Mr. Hope raise regarding the market for the
interest rate swap he was considering for his company? How are those
questions similar to considerations now for developing regulations
over derivatives markets?

While Frank Portnoy was fighting for more financial
markets regulation, guess who was fighting against it tooth and nail?Few remember that Bill Clinton's administration, along with Greenspan and
Levitt, fought successfully against regulation of financial markets.
It's now Deja vu Larry Summers who is the liberal Keynesian scholar behind
President Obama's economic recovery and budget spending.
People remember Larry Summers as Harvard President who was forced out of office
by feminists.
But few remember that he was also Treasury Secretary during the presidency of
Bill Clinton.
Even fewer remember him as avirulent opponent of
financial markets regulation.

In 1997, Brooksley Born warned in congressional
testimony that unregulated trading in derivatives could "threaten our regulated
markets or, indeed, our economy without any federal agency knowing about it."
Born called for greater transparency--disclosure of trades and reserves as a
buffer against losses. Instead of heeding this oracle's warnings, Greenspan,
Rubin & Summers rushed to silence her. As the Times story reveals, Born's wise
warnings "incited fierce opposition" from Greenspan and Rubin who "concluded
that merely discussing new rules threatened the derivatives market." Greenspan
deployed condescension and told Born she didn't know what she doing and she'd
cause a financial crisis . . . In early 1998, according to the Times story, one
of the guys, Larry Summers, called Born to "chastise her for taking steps he
said would lead to a financial crisis. But Born kept at it, unwilling to let
arrogant men undermine her good judgment. But it got tougher out there. In June
1998, Greenspan, Rubin and the then head of the SEC, Arthur Levitt, Jr., called
on Congress "to prevent Ms. Born from acting until more senior regulators
developed their own recommendations." (Levitt now says he regrets that
decision.) Months later, the huge hedge fund Long Term Capital Management nearly
collapsed--confirming some of Born's warnings. (Bets on derivatives were a key
reason.) "Despite that event," the Times reports, " Congress (apparently as a
result of Greenspan & Summer's urging, influence-peddling and pressure) "froze"
Born's Commissions' regulatory authority. The next year, Born left as head of
the Commission.Born did not talk to the Times for their article. What emerges is
a story of reckless, willful and arrogant action and behaviour designed to
undermine a wise woman's good judgment. The three marketeers' disdain for modest
regulation of new and risky financial instruments reveals a faith-based
fundamentalist approach to the management of markets and risk. If there is any
accountability left in our system, Greenspan, Rubin and Summers should not be
telling anyone how to run anything. Instead, Barack Obama might do well to bring
back Brooksley Born and promote to his team economists who haven't contributed
to the ugly mess we're in. Katrina vanden Heuvel, "The Woman
Greenspan, Rubin & Summers Silenced," The Nation, October 9, 2008 ---
http://www.thenation.com/blogs/edcut/370925/the_woman_greenspan_rubin_summers_silencedLink forwarded by Jagdish Gangolly

The Woman Who Tried Early On to Save Our Money and Prevent This Economic
Crisis and Countless Financial FraudsBrooksley Born ---
http://en.wikipedia.org/wiki/Brooksley_BornIn 1964, Brooksley was the first female student in history to become
President of Stanford's Law Review.

The Obama administration has pledged an overhaul of
the financial system, including the way derivatives are regulated. Worrisome to
some observers is the fact that his economic team includes some former Treasury
officials who were lined up in opposition to Born a decade ago."Prophet and Loss," by Rick Schmitt, Stanford Magazine,
March/April 2009, pp. 40-47.

Brooksley Born (the first woman at Stanford to be
president of the Law Review) was named to head the Commodity Futures Trading
Commission in 1996. She “advocated reigning in the huge and growing market
for financial derivatives…Back in the 1990’s, however, Born’s proposal
stirred an almost visceral response from other regulators in the Clinton
administration (notably explosive and rude 1998 reactions from
Treasury Secretary Robert Rubin and Deputy Secretary Larry Summers and SEC
Chairman Arthur Levitt to her suggestion that derivatives swap markets be
regulated) as well as members of Congress and
lobbyists…Ultimately Greenspan and the other regulators foiled Born’s
efforts and Congress took the extraordinary step of enacting legislation
that prohibited her agency from taking any action…Speaking out for the first
time, Born says she takes no pleasure from the turn of events. She says she
was just doing her job based on the evidence in front of her. Looking back,
she laments what she says was the outsized influence of Wall Stret lobbyists
on the process, and the refusal of her fellow regulators, especially
Greenspan, to discuss even modest reforms. ‘Recognizing the dangers…was not
rocket science, but it was contrary to the conventional wisdom and certainly
contrary to the economic interests of Wall Street at the moment,‘ she says.”
As quoted on March 20, 2009 at
http://openpalm.wordpress.com/2009/03/20/the-woman-who-tried-to-save-our-money/

Not only have individual financial institutions
become less vulnerable to shocks from underlying risk factors, but also the
financial system as a whole has become more resilient.Alan Greenspan in 2004 as
quoted by Peter S. Goodman, Taking a Good Look at the Greenspan Legacy," The
New York Times, October 8, 2008 ---
http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?em

“I made a mistake in presuming that the
self-interest of organisations, specifically banks and others, was such that
they were best capable of protecting their own shareholders,” he said. In the
second of two days of tense hearings on Capitol Hill, Henry Waxman, chairman of
the House of Representatives, clashed with current and former regulators and
with Republicans on his own committee over blame for the financial crisis.
"‘I made a mistake,’ admits Greenspan," by Alan Beattie
and James Politi, Financial Times, October 23, 2008 ---
http://www.ft.com/cms/s/0/aee9e3a2-a11f-11dd-82fd-000077b07658.html?nclick_check=1

Rubin, Fed chairman Alan Greenspan and Summers were
concerned that even a hint of regulation would send all the derivatives trading
overseas, costing America business. Summers bluntly insisted that Born drop her
proposal, says Greenberger."The Reeducation of Larry Summers: He's become a champion of
massive government intervention in the economy, and he's even learning how to
play nice. ," by Michael Hirsh and Evan Thomas, Newsweek Magazine, March
2, 2009 ---
http://www.newsweek.com/id/185934

Larry Summers had the rumpled, slightly
sleepy look of a professor who has been up all night solving equations.
President Obama's top economic adviser, the man mainly in charge of the
immense government bailout, splayed himself on a sofa in the Roosevelt Room
in the White House, beneath a portrait of Franklin Roosevelt, and did his
best to be patient with two NEWSWEEK reporters. They were asking him to
explain how he had changed—reeducated himself—since the freewheeling days of
the late 1990s, when Summers had been part of a government that basically
got out of the way of the financial markets as they headed for the edge of
the cliff.

Summers responded by quoting John Maynard
Keynes, whose economic theory calling for massive government spending became
identified with Roosevelt's New Deal and is at the heart of the Obama
administration's stimulus plan. "Keynes famously said of someone who accused
him of inconsistency: 'When circumstances change, I change my opinion',"
said Summers, raising his heavy-lidded eyes at the reporters as he quoted
Keynes's kicker: " 'What do you do?' " The implication, not so subtle, is
that smart people are not dogmatic—stuck in one narrow ideological groove
—but rather open-minded, flexible and intellectually alert—able to change
with the times.

. . .

Some of the stories go well beyond
complaints about his manners.
Brooksley Born, chairwoman of the
Commodity Futures Trading Commission, received a call in March 1998 in her
office in downtown Washington. On the other end was Deputy Treasury
Secretary Summers. According to
witnesses at the CFTC, Summers proceeded to dress her down, loudly and
rudely. "She was ashen," recalls
Born's deputy Michael Greenberger, who walked in as the call was ending.
"She said, 'That was Larry Summers. He was shouting at me'." A few weeks
before, Born had put out a proposal
suggesting that U.S. authorities begin exploring how to regulate the vast
global market in derivatives. Summers's phone call was the first sign that
her humble plan had riled America's reigning economic elite.

Rubin, Fed chairman Alan Greenspan and
Summers were concerned that even a hint of regulation would send all the
derivatives trading overseas, costing America business. Summers bluntly
insisted that Born drop her proposal, says Greenberger.
According to another former CFTC official who would recount the episode only
on condition of anonymity, Born was "astonished" Summers would take the
position "that you shouldn't even ask questions about a market that was
many, many trillions of dollars in notional value—and that none of us knew
anything about."

Arthur Levitt, who was head of the SEC at
the time of Born's proposal, today admits flatly that she had things right
about derivatives while he, Rubin, Greenspan and Summers didn't. ("All
tragedies in life are preceded by warnings," Levitt says. "We had a warning.
It was from Brooksley Born. We didn't listen.") Summers told NEWSWEEK: "I
believed at the time, and believe much more strongly today, that new
regulations with respect to systemic risk were appropriate and necessary,
but expressed the strong view of Secretary Rubin, chairman Greenspan and SEC
chief Levitt that the way the CFTC was proposing to go about it was likely
to be ineffective and itself imposed major risks into the market." (At the
time, the Rubin Treasury Department argued against the Born proposal by
maintaining that the CFTC didn't have legal jurisdiction.) Still, Summers
allowed that "there's no question that with hindsight, stronger regulation
would have been appropriate" before the financial crash. He added: "Large
swaths of economics are going to have to be rethought on the basis of what's
happened." In the past year Summers has refashioned himself as a champion of
intensive financial regulation. In his last column for the Financial Times
before joining the Obama administration, Summers said the pendulum "should
now swing towards an enhanced role for government in saving the market
system from its excesses and inadequacies."

Continued in article

Unlike many other nations that either did not have national accounting
standards or had weak and incomplete sets of standards, the FASB over the
years produced the best set of accounting standards in the world (although
there is no such thing a perfect set since companies are always writing
contracts to circumvent most any standard). The FASB standards were heavily
rule-based due to the continual battles fought by the FASB in the trenches
of U.S. firms seeking to manage earnings and keep debt of the balance sheet
with ever-increasing contract complexities such as interest rate swaps
invented in the 1980s, SPE ploys, securitization "sales," synthetic leasing,
etc.

The experiences
of those frazzled executives in charge of reducing risks in the
credit derivatives market are starting to resemble Alice’s
adventures in Wonderland. Alice shrank after drinking a potion, but
was then too small to reach the key to open the door. The cake she
ate did make her grow, but far too much. It was not until she found
a mushroom that allowed her to both grow and shrink that she was
able to adjust to the right size, and enter the beautiful garden. It
took an awfully long time, with quite a number of unpleasant
experiences, to get there. Aline van Duyn, "The adventure never
ends in the derivatives Wonderland," Financial Times,
September 11, 2008 --- Click Here

While Lehman
Brothers was fighting for its life in the markets today, it was also
battling in a Senate panel's hearing on whether the company and
others created a set of financial products whose primary purpose is
to dodge taxes owned on U.S. stock dividends. The "most compelling"
reason for entering into dividend-related stock swaps are the tax
savings, Highbridge Capital Management Treasury and Finance Director
Richard Potapchuk told the Senate's Permanent Subcommittee on
Investigations. Lehman Brothers (nyse: LEH - news - people ), Morgan
Stanley (nyse: MS - news - people ) and Deutsche Bank (nyse: DB -
news - people ) are among the companies behind the products. Anitia Raghaven, The Tax Dodge Derivative, Forbes,
September 11, 2008 ---
Click Here

There will be a time “beyond crisis,” asserts Robert C.
Merton, who delves into the dense science of derivatives — a field he has
fundamentally shaped — to explain how the vast global economic collapse has come
about, and how financial innovations at the heart of the collapse could also be
tools for reconstruction. Merton uses deceptively simple graphs to show how risk
propagated rapidly across financial networks, bringing down financial
institutions. While he admits the crisis “is very big and complicated,” Merton
boils a piece of it down to the use of put options, a derivative contract that’s
been around since the 17th century. This asset-value insurance contract, a
guarantee of debt, is the basis for the credit default swaps widely adopted by
financial giants in the last few years — now widely regarded as a primary cause
of the meltdown. It turns out, says Merton, that the put “makes risky debt very
complicated, and treacherous…” In these puts, if the value of assets goes down,
the guarantee value goes up, so the value of the written insurance is worth
more. The value of this guarantee is very sensitive to the movement of the
underlying asset. When dealing with puts on the local level, this movement can
be tracked and managed more easily. But when financial institutions manipulate
bundles of assets (for instance, mortgage-backed securities), the increase in
risk proves non-linear. Add some volatility, like the jolts posed by widespread
drops in housing prices, and the difference between the decline in asset value
and the value of the guarantee becomes enormous — leading to mountains of debt
and felling behemoths like AIG (insurer to lenders).
"Video: Robert C. Merton: Observations on the Science of Finance in the
Practice of Finance," Simoleon Sense, April 6, 2009 ---
Click Here
Snipped Link ---
http://snipurl.com/mertenputs [www_simoleonsense_com]
Jensen Comment
Nobel Economist Robert Merton knows very well about the dense science and
practice of derivatives. He was a principle loser in Long Term Capital's 1993
"Trillion Dollar Bet" that nearly brought down Wall Street ---
http://www.trinity.edu/rjensen/FraudRotten.htm#LTCM

Pricing of gold forward rate ---
http://cij.inspiriting.com/?p=491Accounting
instructors having to teach IAS 39 or FAS 133 often seek illustrations about the
required valuation/auditing of derivatives at fair value. Since gold fever has
increased in this economic crisis, valuation of forward contracts in gold may be
doubly of interest to students

Beginning in 1979, FAS 33 required large corporations to provide a
supplementary schedule of condensed balance sheets and income statements
comparing annual outcomes under three valuation bases --- Unadjusted Historical
Cost, Price Level Adjusted (PLA) Historical Cost, and Current Cost Entry Value
(adjusted for depreciation and amortization). Companies complained heavily that
users did not obtain value that justified the cost of implementing FAS 33.
Analysts complained that the FASB allowed such crude estimates that the FAS 33
schedules were virtually useless, especially the Current Cost estimates. The
FASB rescinded FAS 33 when it issued FAS 89 in 1986.

Current cost accounting by whatever name (e.g., current or replacement cost)
entails the historical cost of balance sheet items with current (replacement)
costs. Depreciation rates can be re-set based upon current costs rather than
historical costs. Replacement cost accounting is a cost allocation system and not a fair value
system of accounting.

Beginning in 1979, FAS 33 required large corporations to provide a
supplementary schedule of condensed balance sheets and income statements
comparing annual outcomes under three valuation bases --- Unadjusted Historical
Cost, PLA-Adjusted historical cost, and Current Cost Entry Value (adjusted for
depreciation and amortization). Companies are no longer required to generate FAS
33-type comparisons. The primary basis of accounting in the U.S. is unadjusted
historical cost with numerous exceptions in particular instances. For example,
price-level adjustments may be required for operations in hyperinflation
nations. Exit value accounting is required for firms deemed highly likely to
become non-going concerns. Exit value accounting is required for personal
financial statements (whether an individual or a personal partnership such as
two married people). Economic (discounted cash flow) valuations are required for
certain types of assets and liabilities such as pension liabilities. Hence in
the United States and virtually every other nation, accounting standards do not
require or even allow one single basis of accounting. Beginning in January 2005,
all nations in the European Union adopted the IASB's international standards
that have moved closer and closer each year to the FASB/SEC standards of the
United States.

Advantages of Entry Value (Current Cost, Replacement Cost) Accounting

Conforms to capital
maintenance theory that argues in favor of matching current revenues with
what the current costs are of generating those revenues. For example, if
historical cost depreciation is $100 and current cost depreciation is $120,
current cost theory argues that an excess of $20 may be wrongly classified
as profit and distributed as a dividend. When it comes time to replace the
asset, the firm may have mistakenly eaten its seed corn.

If the accurate
replacement cost is known and can be matched with current selling prices,
the problems of finding indices for price level adjustments are avoided.

Avoids to some extent
booking the spread between selling price and the wholesale "cost" of an
item. Recording a securities “inventory” or any other inventory at exit
values rather than entry values tends to book unrealized sales profits
before they’re actually earned. There may also be considerably variability
in exit values vis-à-vis replacement costs.

Although I am not in general a current cost (replacement
cost, entry-value) advocate, I think you and Tom are missing the main theory
behind the passage of the now defunct FAS 33 that leaned toward replacement cost
valuation as opposed to exit valuation.

The best illustration in favor of replacement cost
accounting is the infamous Blue Book used by automobile and truck dealers that
lists composite wholesale trading for each make and model of vehicle in recent
years. The Blue Book illustration is relevant with respect to business equipment
currently in use in a company since virtually all that equipment is now in the
“used” category, although most of it will not have a complete Blue Book per se.

The theory of Blue Book pricing in accounting is that each
used vehicle is unique to a point that exit valuation in particular instances is
very difficult since no two used vehicles have the same exit value in a
particular instances. But the Blue Book is a market-composite hundreds of dealer
transactions of each make and model in recent months and years on the wholesale
market.

Hence I don’t have any idea about what my 1999 Jeep
Cherokee in particular is worth, and any exit value estimate of my vehicle is
pretty much a wild guess relative to what it most likely would cost me to
replace it with another 1999 Jeep Cherokee from a random sample selection among
2,000 Jeep dealers across the United States. I merely have to look up the Blue
Book price and then estimate what the dealer charges as a mark up if I want to
replace my 1999 Jeep Cherokee.

Since Blue Book pricing is based upon actual trades that
take place, it’s far more reliable than exit value sticker prices of vehicles in
the sales lots.

ConclusionIt is sometimes the replacement market of actual transactions that makes a Blue
Book composite replacement cost more reliable than an exit value estimate of
what I will pay for a particular car from a particular dealer at retail. Of
course this argument is not as crucial to financial assets and liabilities that
are not as unique as a particular used vehicle. Replacement cost valuation for
accounting becomes more defensible for non-financial assets.

Discovery of accurate replacement costs is
virtually impossible in times of changing technologies and newer production
alternatives. For example, some companies are using data processing
hardware and software that no longer can be purchased or would never be
purchased even if it was available due to changes in technology. Some
companies are using buildings that may not be necessary as production
becomes more outsourced and sales move to the Internet. It is possible to
replace used assets with used assets rather than new assets. Must current
costs rely only upon prices of new assets?

Discovering current costs is prohibitively
costly if firms have to repeatedly find current replacement prices on
thousands or millions of items.

Accurate derivation of replacement cost is
very difficult for items having high variations in quality. For example,
some ten-year old trucks have much higher used prices than other used trucks
of the same type and vintage. Comparisons with new trucks is very difficult
since new trucks have new features, different expected economic lives,
warranties, financing options, and other differences that make comparisons
extremely complex and tedious. In many cases, items are bought in basket
purchases that cover warranties, insurance, buy-back options, maintenance
agreements, etc. Allocating the "cost" to particular components may be quite
arbitrary.

Use of "sector" price indices as surrogates
compounds the price-index problem of general price-level adjustments. For
example, if a "transportation" price index is used to estimate replacement
cost, what constitutes a "transportation" price index? Are such indices
available and are they meaningful for the purpose at hand? When FAS 33 was
rescinded in 1986, one of the major reasons was the error and confusion of
using sector indices as surrogates for actual replacement costs.

Current costs tend to
give rise to recognition of holding gains and losses not yet realized.

Bob Jensen

Hi Again Tom,

I would
not trash a lawn mower under warranty even if I bought the new one. My
motto for warranty providers is to make them pay and pay for the lemons
they sell to me.

In my
case it was a pain for Sears and (less for me) to have to keep returning
to my home to fix my snow thrower. But in the process, my stubborn
nature paid off for millions of consumers who had trouble with their
chute-cable freeze ups on snow throwers.I think that Craftsman is mostly
a boiler plate for put on snow throwers manufactured for a variety of
retail distributors. In any case, engineers finally solved the chute
cable problem by simply shortening the cables from about four feet to
two feet. Now my snow thrower works terrific. If you had persisted with
your lawn mower problem, maybe engineers would have discovered a miracle
solution.

The key
is to have an onsite warranty. If you have to haul the item to a service
center, the hassle is too much of a pain in the tail.

What I
wonder about your IFRS comment below is what constitutes “adequate”
accumulated depreciation? Obviously, “adequate” cannot mean the full
cost of replacement. It could mean the cost of replacement depreciated
over the current fraction of estimated useful life, but this would be
tantamount to replacement cost accounting. I don’t think IFRS has
abandoned historical cost accounting in favor of replacement cost
accounting.

Therefore, I’ve very confused as to how “adequate” is defined in your
message below.

As to my
recommendation for financial statements, I think the only practical
solution is M2M for financial items and historical cost for
non-financial items still in use (with LCM only for permanently-impaired
inventory). Something like FAS 33 requiring supplemental disclosures of
entry and exit values with price level adjustments would be great, but
the requirements for measurement would have to be far more accurate than
crude sector price index adjustments.

I think
that unrealized gains and losses due to M2M should not impact current
earnings. These should be deferred in AOCI or something equivalent.

Bob Jensen

Hi again Tom,

I agree with what you state about
covariances of replacement cost estimates, but it is important to note
that replacement cost accounting is really a cost allocation process
rather than a valuation process for non-financial items subject to
depreciation and amortization. Depreciation and amortization allocation
formulas use such arbitrary estimates of economic lives, salvage values,
and cost allocation patterns that it’s not clear why additive
aggregation is any more meaningful under replacement cost aggregations
than it is under historical cost aggregations. Neither one aggregates to
anything we can meaningfully call value in use.

Companies are no longer required to
generate FAS 33-type comparisons. The primary basis of accounting in
the U.S. is unadjusted historical cost with numerous exceptions in
particular instances. For example, price-level adjustments may be
required for operations in hyperinflation nations. Exit value
accounting is required for firms deemed highly likely to become
non-going concerns. Exit value accounting is required for personal
financial statements (whether an individual or a personal partnership
such as two married people). Economic (discounted cash flow) valuations
are required for certain types of assets and liabilities such as pension
liabilities. Exit value accounting is required for impaired items such
as damaged inventories and inoperable machinery.

Hence in the United States and virtually every other nation, accounting
standards do not require or even allow one single basis of accounting.
Beginning in January 2005, all nations in the European Union adopted the
IASB's international standards that have moved closer and closer each
year to the FASB/SEC standards of the United States.

The FASB and the IASB state that "value in use" is the ideal valuation
measure if it can be measured reliably at realistic estimation costs.
Exit value and economic (discounted cash flow) generally do not meet
these two criteria for value in use of non-financial items. There is
nearly always no practical means of estimating higher order covariances.
and additivity aggregations are meaningless without such covariances.
In the case of economic valuation, estimation of future cash flows and
discount rates enters the realm of fantasy for long-lived items.
Alsoreliable exit value estimation of some items like all the hotel
properties of Days Inns can be very expensive, which is a major reason
Days Inns only did it once for financial reporting purposes in 1987.
Accordingly, "value in use" is an ideal which cannot be practically
achieved under either exit or economic valuation methods.

The FASB and the IASB state that "value in use" is the ideal valuation
measure, but this ideal can never be achieved with cost allocation
methods. Both historical cost and replacement (current, entry) value
"valuation" methods are not really valuation methods at all. These are
cost allocation methods that for items subject to depreciation or
amortization in value are reliant upon usually arbitrary estimates of
non-financial item useful lives, value decline assumptions such as
straight line or double declining balance declines, and salvage value
estimates. Under historical cost, the book value thus becomes an
arbitrary residual of the rationing of original cost by arbitrary cost
allocation formulas. Under replacement (current, entry) cost allocation
the estimated current replacement costs are subjected to n arbitrary
residual of the rationing of replacement cost by arbitrary cost
allocation formulas.

Although both historical and replacement cost allocations over time
avoid covariance problems in additive aggregations of book values, the
meanings of such aggregations are of very dubious utility to investors
and other decision makers. For example suppose the $10 million 2008 book
value of a fleet of passenger vans is added to the $200 million 2008
book value of Days Inn hotel properties, what does the $210 million
aggregation mean to anybody?

Both the passenger vans and hotel buildings have been subjected to
arbitrary estimates of economic lives, salvage values, and depreciation
patters such as double declining balance depreciation for vans and
straight-line depreciation for hotel buildings. This is the case whether
historical cost or current replacement costs have been allocated by
depreciation formulas.

Hence it is not clear that for going concern companies that have heavy
investments in non-financial assets that any known addition of
individual items makes any sense under economic, exit, entry, or
historical cost book value estimation process. Aggregations might make
some sense for financial items with negligible covariances, but for
non-financial items. Attempts to estimate total value itself basted upon
stock market marginal trades are misleading since marginal trades of a
small proportion of shares ignores huge blockage factors valuations,
especially blockage factors that carry managerial control along with the
blockage purchase. Countless mergers and acquisitions repeatedly
illustrate that estimations of total values of companies are generally
subject to huge margins of error, especially when intangibles play an
enormous part of the value of an enterprise.

Both the FASB and the IASB require in many instances that exit value
accounting be used for financial items. In part that is because for
financial items it is often more reasonable to assume zero covariances
among items. The recent banking failures caused by covariance among
toxic mortgage investments lends some doubt to this assumption, but the
issue of David Li’s faltering and infamous Gaussian copula function is
being ignored by both the IASB and the FASB in recommending exit value
accounting for many (most) financial items ---
http://en.wikipedia.org/wiki/Gaussian_copula#Gaussian_copulaFor how the defect in this formula contributed to the 2008 fall of many
banks see --- http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html

I
might add that Bob Herz and the FASB as a whole recognize that
additive aggregation in financial statement items is probably more
misleading than helpful. This is why a very radical proposal is
underway in the FASB to do away with aggregations, including the
presentation of net income and earnings-per-share bottom liners ---
http://www.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

The
above link also discusses the vehement disagreement between Bob Herz
and the financial community on the proposal to do away with the
bottom line.

This
bottom line aggregation problem is also bound up in the “quality of
earnings” controversy ---
http://www.trinity.edu/rjensen/Theory01.htm#CoreEarningsHowever, the concept of reporting core earnings is not nearly as
controversial as the proposal not to report any bottom lines

Bob Jensen's threads on
fair value accounting are at various other links:

Whereas entry value is what it will cost to replace an item, exit value is
the value of disposing of the item. It can even be negative in some instances
where costs of clean up and disposal make to exit price negative. Exit value
accounting is required under GAAP for personal financial statements (individuals
and married couples) and companies that are deemed likely to become non-going
concerns. See "Personal Financial Statements," by Anthony Mancuso, The CPA
Journal, September 1992 ---
http://www.nysscpa.org/cpajournal/old/13606731.htm

Some theorists advocate exit value accounting for going concerns as well as
non-going concerns. Both nationally (particularly under FAS 115 and FAS 133) and
internationally (under IAS 32 and 39 for), exit value accounting is presently
required in some instances for financial instrument
assets and liabilities. Both the FASB and the IASB have exposure drafts
advocating fair value accounting for all financial instruments.

If an item is
viewed as a financial instrument rather than inventory, the
accounting becomes more complicated under FAS 115. Traders in
financial instruments adjust such instruments to fair value with all
changes in value passing through current earnings. Business firms
who are not deemed to be traders must designate the instrument as
either available-for-sale (AFS) or hold-to-maturity (HTM). A HTM
instrument is maintained at original cost. An AFS financial
instrument must be marked-to-market, but the changes in value pass
through OCI rather than current earnings until the instrument is
actually sold or otherwise expires. Under international standards,
the IASB requires fair value adjustments for most financial
instruments. This has led to strong reaction from businesses around
the world, especially banks. There are now two major working group
debates. In 1999 the Joint Working Group of the Banking Associations
sharply rebuffed the IAS 39 fair value accounting in two white
papers that can be downloaded from
http://www.iasc.org.uk/frame/cen3_112.htm.

·Accounting for financial Instruments for Banks
(concludes that a modified form of historical cost is optimal for bank
accounting). The issue date is October 4, 1999.

Advantages of Exit Value (Liquidation, Fair Value) Accounting

In the case of financial assets and
liabilities, historical costs may be meaningless relative to current exit
values. For example, a forward contract or swap generally has zero
historical cost but may be valued at millions at the current time. Failure
to require fair value accounting provides all sorts of misleading earnings
management opportunities to firms. The above references provide strong
arguments in favor of fair value accounting.

Exit value does not require arbitrary cost
allocation decisions such as whether to use FIFO or LIFO or what
depreciation rate is best for allocating cost over time.

In many instances exit
value accounting is easier to compute than entry values. For example, it is
easier to estimate what an old computer will bring in the used computer
market than to estimate what is the cost of "equivalent" computing power is
in the new computer market.

Exit value reporting is not deemed
desirable or practical for going concern businesses for a number of reasons that
I will not go into in great depth here.

Disadvantages of Exit Value (Liquidation, Fair
Value) Accounting

·Operating
assets are bought to use rather than sell. For example, as long as no
consideration is being given to selling or abandoning a manufacturing plant,
recording the fluctuating values of the land and buildings creates a misleading
fluctuation in earnings and balance sheet volatility. Who cares if the value of
the land went up by $1 million in 1994 and down by $2 million in 1998 if the
plant that sits on the land has been in operation for 60 years and no
consideration is being given to leaving this plant?

· Some assets like
software, knowledge databases, and Web servers for e-Commerce cost millions of
dollars to develop for the benefit of future revenue growth and future expense
savings. These assets may have immense value if the entire firm is sold, but
they may have no market as unbundled assets. In fact it may be impossible to
unbundle such assets from the firm as a whole. Examples include the Enterprise
Planning Model SAP system in firms such as Union Carbide. These systems costing
millions of dollars have no exit value in the context of exit value accounting
even though they are designed to benefit the companies for many years into the
future

.

· Exit value
accounting records anticipated profits well in advance of transactions. For
example, a large home building company with 200 completed houses in inventory
would record the profits of these homes long before the company even had any
buyers for those homes. Even though exit value accounting is billed as a
conservative approach, there are instances where it is far from conservative

.

· Value of a
subsystem of items differs from the sum of the value of its parts. Investors may
be lulled into thinking that the sum of all subsystem net assets valued at
liquidation prices is the value of the system of these net assets. Values may
differ depending upon how the subsystems are diced and sliced in a sale.

· Appraisals of
exit values are both to expensive to obtain for each accounting report date and
are highly subjective and subject to enormous variations of opinion. The U.S.
Savings and Loan scandals of the 1980s demonstrated how reliance upon appraisals
is an invitation for massive frauds. Experiments by some, mostly real estate
companies, to use exit value-based accounting died on the vine, including
well-known attempts decades ago by TRC, Rouse, and Days Inn.

· Exit values are
affected by how something is sold. If quick cash is needed, the best price may
only be half of what the price can be by waiting for the right time and the
right buyer.

· Financial
contracts that for one reason or another are deemed as to be "held-to-maturity"
items may cause misleading increases and decreases in reported values that will
never be realized. A good example is the market value of a fixed-rate bond that
may go up and down with interest rates but will always pay its face value at
maturity no matter what happens to interest rates.

·Exit value markets are often thin and inefficient
markets.

Hi Pat,

My main
computer that contains the IASB literature is in the shop at the moment.
But I will do the best I can with other references.

Value in
use originates in the concept that a firm computing net present value of
an asset will use its own optimal use future stream of cash flows where
that stream may not be attainable by any other company ---
http://en.wikipedia.org/wiki/Value-in-useThe Glossary of the FASB’s Accounting Standards Database Codification
database defines “value in use” as “The
amount determined by discounting the future cash flows (including the
ultimate proceeds of disposal) expected to be derived from the use of an
asset at an appropriate rate that allows for the risk of the activities
concerned”

All too
often Value in Use (VIU) is equated to discounted future cash flows of
an item in optimal use. Discounted cash flow estimation may be a
fantasyland ideal that is not altogether necessary. For example, if IBM
has a factory robot assembling computer components, it is virtually
impossible to trace future computer sale cash flows to the portion of
cash flows attributed to one assembly robot. Exit value is probably a
useless surrogate for an installed factory robot since exit value is
absurdly low relative to VIU of the robot. Other surrogate valuations
may be much closer to VIU, including the replacement cost appropriately
adjusted for differences in economic life of the present robot versus a
now robot. The thing about VIU is that, when exit value is highly
misleading, then other valuation estimates are possible, including
replacement cost based upon current entry values for an IBM purchase of
a new robot plus engineering estimates of current installation cost of a
replacement robot.

Exit
value is generally considered an exchange price that’s agreed upon by a
buyer and a seller. Both buyer and seller may have different values in
use such as when Days Inn sells 200 hotels to Holiday Inn. Covariance
with brand name and other intangibles means that the value in use of
each hotel differs for Days Inn versus Holiday Inn.

Both the
FASB and the IASB generally consider exit value to be the worst
possible seller’s use (e.g., forced liquidation) of the item in
liquidation rather than use in a going concern. It is very misleading
when a going concern owner has zero intention to sell the item. The
ideal is value in use rather than exit value for a going concern having
an item that is operational. The presumption is that the exit value may
be the worst possible use value for the seller but is almost certainly
not the best possible use value for the buyer. Otherwise the buyer would
not agree on that exchange price.

In the
August 2008 annual American Accounting Association meetings Tom
Linsmeier and another speaker from BYU put great emphasis on how exit
value is the worst possible value for present owners that are going
concerns. They both claimed preference for Value in Use.

Neither
the FASB nor the IASB is entirely consistent on value in use being the
ideal. Paragraphs A5-A12 in FAS 157 illustrate how value in use (VIU)
may be used in fair value measurement. However, keep in mind that
current fair value accounting requirements apply mostly to financial
items except in a few isolated instances of non-financial items such as
precious metal inventories. VIU measurement controversies are usually
much greater for non-financial items such as fixed operating assets and
real estate investments. The controversy has and always will be the
trade-off between objectivity of valuation versus the possibility that
the more objective valuations may be less useful or even very
misleading. For example, a forced liquidation exchange value of an item
may be very misleading if the owner has zero intention of selling. On
the other hand, a VIU that depends heavily on subjective estimates
subject to wide measurement error may also highly misleading and make
fraud easier.

A6. Highest and best use is a valuation concept that refers broadly to
the use of an asset that would maximize the value of the asset or the
group of assets in which the asset would be used by market participants.
For some assets, in particular, nonfinancial assets, application of the
highest-and-best-use concept could have a significant effect on the fair
value measurement.

Examples 1–3 illustrate the application of the highest-and-best-use
concept in situations in which nonfinancial assets are newly acquired.Paragraph A6 of FAS 157 ---
http://www.fasb.org/pdf/aop_FAS157.pdf

Traditionally, value in-use fairly reflects the economics of a specific
transaction. But the FASB has indicated in recently issued guidelines,
that it prefers looking to the market, rather than company-specific
valuations. Regardless of which approach is chosen, future income
statements will be affected. The value in-use approach will generally
result in higher depreciation expense and lower reported earnings. The
value in-exchange approach will usually result in more of the initial
purchase price being allocated to goodwill, which must be tested for
impairment every year.“SFAS 141 Impacts Choice of Method Used to Value PP & E” ---
http://www.valuationresearch.com/content/Knowledge_center/back_issues/35_2002_2.htm

C38. In the context of the related guidance included in the Exposure
Draft, some respondents referred to possible conflicts between the
in-use valuation premise and the exchange notion encompassed within the
definition of fair value. In this Statement, the Board clarified that
the exchange notion applies regardless of the valuation premise used to
measure the fair value of an asset. Whether using an in-use or an
in-exchange valuation premise, the measurement is a market-based
measurement determined based on the use of an asset by market
participants, not a value determined based solely on the use of an asset
by the reporting entity (a value-in-use or entity-specific

Jensen
CommentHence the FASB offers ambiguous guidance on exchange value versus value
in use. The FASB likes exchange value (VIE) in terms of objectivity
relative to the dastardly subjectivity of value in use (VIU). At the
same time the FASB hates exchange valuation that puts asset values at
the worst possible use of the asset, e.g. forced liquidation valuation
of an asset that a going concern has every intention of using at much
higher value. Also there’s absolutely no forced liquidation value for
portions of fixed assets such as enormous installation costs of ERP and
other database systems, blast or electric furnaces producing steel,
factory robots, and assets requiring millions of dollars in winning
governmental permits, many of which are not transferrable in liquidation
sales. . Of
course at present, neither the FASB nor the IASB require fair value
accounting for most types of non-financial assets, including steel
furnaces, ERP, factory robots, etc. If the FASB extends fair value
accounting to all non-financial items, the FASB will most certainly have
to back off priority for objective exchange values for items having zero
exchange value such as non-transferable components of fixed assets such
as installation costs.

The IASB is
as inconsistent as the FASB on issues of VIU versus VIE. The ideal is
VIU that can be objectively determined such as an asset or liability
with contractual future cash flows and minimal loss risk. As VIU becomes
more subjective in terms managerial choices as to the future cash flow
stream of 200 hotels in the hands of Days Inns versus Holiday Inns, then
VIE is probably going to be preferred by the FASB and the IASB. But this
can be misleading, because valuing hotels at a forced liquidation exit
value may be more misleading than historical cost book value when
there’s no intention whatsoever for the owner to sell the hotel. This
would be especially misleading if Holiday Inns had to use forced
liquidation exit values in this period of distressed real estate values
where owners have no intention of selling out at distressed real estate
values.
Of course at present, neither the FASB nor the IASB require fair value
accounting for most types of non-financial assets, including real
estate. If fair value accounting is extended to all non-financial
assets, I think that preferences for VIE will have to give way to VIU.
VIE likely to be highly misleading (overly conservative) when trying to
evaluate investment potential of a successful going concern.

Value in
use issues also rear up in standards involving value impairment tests
such as

Value in use [IAS 36, par. 18; IAS 38,
par. 83]

Economic Value (Discounted Cash Flow, Present
Value) Accounting

There are over 100 instances where present GAAP requires that historical cost
accounting be abandoned in favor of discounted cash flow accounting (e.g., when
valuing pension liabilities and computing fair values of derivative financial
instruments). These apply in situations where future cash inflows and outflows
can be reliably estimated and are attributable to the particular asset or
liability being valued on a discounted cash flow basis.

How does one allocate a portion of the cash
flows of General Motors to a single welding machine in Tennessee? Or how
does one allocate the portion of the sales price of a single car to the
robot that welded a single hinge on one of the doors? How does one allocate
the price of a bond to the basic obligation, the attached warrants, the call
option in the fine print, and other possible embedded derivatives in the
contract? The problem lies in the arbitrary nature of deciding what system
of assets and liabilities to value as a system rather than individual
components. Then what happens when the system is changed in some way? In
order to see how complex this can become, note the complicated valuation
assumptions in a paper entitled "Implementation of an Option Pricing-Based
Bond Valuation Model for Corporate Debt and Its Components," by M.E. Barth,
W.R. Landsman, and R.J. Rendleman, Jr., Accounting Horizons, December
2000, pp. 455-480.

Cash flows are virtually impossible to
estimate except when they are contractually specified. How can Amazon.com
accurately estimate the millions and millions of dollars it has invested in
online software?

Even when cash flows can be reliably
estimated, there are endless disputes regarding the appropriate discount
rates.

There are two sources of covariance that need
to be dealt with: (1) covariances among assets recognized, and (2)
covariances between recognized and non-recognized assets. I think
replacement cost rules can easily cope with (1) without sacrificing
additivity – i.e., that total assets on the balance sheet will represent
the total minimum current cost of replacing the recognized assets of the
business entity, assuming (for the moment) that there are no
unrecognized assets. There may be issues of allocating the replacement
cost among asset categories, but I don’t see that as a big problem,
because everything adds up to the desired number.

Since the nature of the assets we don’t
recognize are very different in nature from the ones we recognize, I
don’t see anything irrational (you may be able to enlighten me here)
about having an expectation that the covariances of the second type,
above, are 0. An expectation is different from a “declaration” or an
“assumption.”

I feel like a greased pig trying to escape your
clutches! But unlike the pig, I’m learning a lot.

Best,

Tom

April 4, 2009 reply from Bob Jensen

Hi Tom,

I agree with what you state about
covariances of replacement cost estimates, but it is important to note
that replacement cost accounting is really a cost allocation process
rather than a valuation process for non-financial items subject to
depreciation and amortization. Depreciation and amortization allocation
formulas use such arbitrary estimates of economic lives, salvage values,
and cost allocation patterns that it’s not clear why additive
aggregation is any more meaningful under replacement cost aggregations
than it is under historical cost aggregations. Neither one aggregates to
anything we can meaningfully call value in use.

Companies are no longer required to generate FAS 33-type comparisons.
The primary basis of accounting in the U.S. is unadjusted historical
cost with numerous exceptions in particular instances. For example,
price-level adjustments may be required for operations in hyperinflation
nations. Exit value accounting is required for firms deemed highly
likely to become non-going concerns. Exit value accounting is required
for personal financial statements (whether an individual or a personal
partnership such as two married people). Economic (discounted cash
flow) valuations are required for certain types of assets and
liabilities such as pension liabilities. Exit value accounting is
required for impaired items such as damaged inventories and inoperable
machinery.

Hence in the United States and virtually every other nation, accounting
standards do not require or even allow one single basis of accounting.
Beginning in January 2005, all nations in the European Union adopted the
IASB's international standards that have moved closer and closer each
year to the FASB/SEC standards of the United States.

The FASB and the IASB state that "value in use" is the ideal valuation
measure if it can be measured reliably at realistic estimation costs.
Exit value and economic (discounted cash flow) generally do not meet
these two criteria for value in use of non-financial items. There is
nearly always no practical means of estimating higher order covariances.
and additivity aggregations are meaningless without such covariances.
In the case of economic valuation, estimation of future cash flows and
discount rates enters the realm of fantasy for long-lived items.
Alsoreliable exit value estimation of some items like all the hotel
properties of Days Inns can be very expensive, which is a major reason
Days Inns only did it once for financial reporting purposes in 1987.
Accordingly, "value in use" is an ideal which cannot be practically
achieved under either exit or economic valuation methods.

The FASB and the IASB state that "value in use" is the ideal valuation
measure, but this ideal can never be achieved with cost allocation
methods. Both historical cost and replacement (current, entry) value
"valuation" methods are not really valuation methods at all. These are
cost allocation methods that for items subject to depreciation or
amortization in value are reliant upon usually arbitrary estimates of
non-financial item useful lives, value decline assumptions such as
straight line or double declining balance declines, and salvage value
estimates. Under historical cost, the book value thus becomes an
arbitrary residual of the rationing of original cost by arbitrary cost
allocation formulas. Under replacement (current, entry) cost allocation
the estimated current replacement costs are subjected to n arbitrary
residual of the rationing of replacement cost by arbitrary cost
allocation formulas.

Although both historical and replacement cost allocations over time
avoid covariance problems in additive aggregations of book values, the
meanings of such aggregations are of very dubious utility to investors
and other decision makers. For example suppose the $10 million 2008 book
value of a fleet of passenger vans is added to the $200 million 2008
book value of Days Inn hotel properties, what does the $210 million
aggregation mean to anybody?

Both the passenger vans and hotel buildings have been subjected to
arbitrary estimates of economic lives, salvage values, and depreciation
patters such as double declining balance depreciation for vans and
straight-line depreciation for hotel buildings. This is the case whether
historical cost or current replacement costs have been allocated by
depreciation formulas.

Hence it is not clear that for going concern companies that have heavy
investments in non-financial assets that any known addition of
individual items makes any sense under economic, exit, entry, or
historical cost book value estimation process. Aggregations might make
some sense for financial items with negligible covariances, but for
non-financial items. Attempts to estimate total value itself basted upon
stock market marginal trades are misleading since marginal trades of a
small proportion of shares ignores huge blockage factors valuations,
especially blockage factors that carry managerial control along with the
blockage purchase. Countless mergers and acquisitions repeatedly
illustrate that estimations of total values of companies are generally
subject to huge margins of error, especially when intangibles play an
enormous part of the value of an enterprise.

Both the FASB and the IASB require in many instances that exit value
accounting be used for financial items. In part that is because for
financial items it is often more reasonable to assume zero covariances
among items. The recent banking failures caused by covariance among
toxic mortgage investments lends some doubt to this assumption, but the
issue of David Li’s faltering and infamous Gaussian copula function is
being ignored by both the IASB and the FASB in recommending exit value
accounting for many (most) financial items ---
http://en.wikipedia.org/wiki/Gaussian_copula#Gaussian_copulaFor how the defect in this formula contributed to the 2008 fall of many
banks see --- http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html

I might add that Bob Herz and the FASB as a whole recognize that
additive aggregation in financial statement items is probably more
misleading than helpful. This is why a very radical proposal is underway
in the FASB to do away with aggregations, including the presentation of
net income and earnings-per-share bottom liners ---
http://www.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

The above link also discusses the vehement disagreement between Bob
Herz and the financial community on the proposal to do away with the
bottom line.

This bottom line aggregation problem is also bound up in the “quality
of earnings” controversy --- http://www.trinity.edu/rjensen/Theory01.htm#CoreEarningsHowever, the concept of reporting core earnings is not nearly as
controversial as the proposal not to report any bottom lines.

You said: "The FASB and the IASB state that "value
in use" is the ideal valuation measure if it can be measured reliably at
realistic estimation costs."

Given that, for many years now, they have both been
working toward reliable external measurements rather than internal
measurements, could you point me to where in the literature "value in use"
is considered the "ideal"?

Value in use
originates in the concept that a firm computing net present value of an
asset will use its own optimal use future stream of cash flows where that
stream may not be attainable by any other company ---
http://en.wikipedia.org/wiki/Value-in-useThe Glossary of the FASB’s Accounting Standards Database Codification
database defines “value in use” as “The amount
determined by discounting the future cash flows (including the ultimate
proceeds of disposal) expected to be derived from the use of an asset at an
appropriate rate that allows for the risk of the activities concerned”

All too often
Value in Use (VIU) is equated to discounted future cash flows of an item in
optimal use. Discounted cash flow estimation may be a fantasyland ideal that
is not altogether necessary. For example, if IBM has a factory robot
assembling computer components, it is virtually impossible to trace future
computer sale cash flows to the portion of cash flows attributed to one
assembly robot. Exit value is probably a useless surrogate for an installed
factory robot since exit value is absurdly low relative to VIU of the robot.
Other surrogate valuations may be much closer to VIU, including the
replacement cost appropriately adjusted for differences in economic life of
the present robot versus a now robot. The thing about VIU is that, when exit
value is highly misleading, then other valuation estimates are possible,
including replacement cost based upon current entry values for an IBM
purchase of a new robot plus engineering estimates of current installation
cost of a replacement robot.

Another
approach to measure value in use is to have engineers estimate the cost
savings of an assembly robot vis-a-vis the production costs without the
robot. Of course this requires some subjectivity. Some of this data may have
been generated at the time the decision was made to invest in the robot.

Exit value is
generally considered an exchange price that’s agreed upon by a buyer and a
seller. Both buyer and seller may have different values in use such as when
Days Inn sells 200 hotels to Holiday Inn. Covariance with brand name and
other intangibles means that the value in use of each hotel differs for Days
Inn versus Holiday Inn.

Both the FASB
and the IASB generally consider exit value to be the worst possible
seller’s use (e.g., forced liquidation) of the item in liquidation
rather than use in a going concern. It is very misleading when a going
concern owner has zero intention to sell the item. The ideal is value in use
rather than exit value for a going concern having an item that is
operational. The presumption is that the exit value may be the worst
possible use value for the seller but is almost certainly not the best
possible use value for the buyer. Otherwise the buyer would not agree on
that exchange price.

In the August
2008 annual American Accounting Association meetings Tom Linsmeier and
another speaker from BYU put great emphasis on how exit value is the worst
possible value for present owners that are going concerns. They both claimed
preference for Value in Use.

Neither the FASB
nor the IASB is entirely consistent on value in use being the ideal.
Paragraphs A5-A12 in FAS 157 illustrate how value in use (VIU) may be used
in fair value measurement. However, keep in mind that current fair value
accounting requirements apply mostly to financial items except in a few
isolated instances of non-financial items such as precious metal
inventories. VIU measurement controversies are usually much greater for
non-financial items such as fixed operating assets and real estate
investments. The controversy has and always will be the trade-off between
objectivity of valuation versus the possibility that the more objective
valuations may be less useful or even very misleading. For example, a forced
liquidation exchange value of an item may be very misleading if the owner
has zero intention of selling. On the other hand, a VIU that depends heavily
on subjective estimates subject to wide measurement error may also highly
misleading and make fraud easier.

A6. Highest
and best use is a valuation concept that refers broadly to the use of an
asset that would maximize the value of the asset or the group of assets in
which the asset would be used by market participants. For some assets, in
particular, nonfinancial assets, application of the highest-and-best-use
concept could have a significant effect on the fair value measurement.

Examples 1–3
illustrate the application of the highest-and-best-use concept in situations
in which nonfinancial assets are newly acquired.Paragraph A6 of FAS 157 ---
http://www.fasb.org/pdf/aop_FAS157.pdf

Traditionally, value in-use fairly reflects the economics of a specific
transaction. But the FASB has indicated in recently issued guidelines, that
it prefers looking to the market, rather than company-specific valuations.
Regardless of which approach is chosen, future income statements will be
affected. The value in-use approach will generally result in higher
depreciation expense and lower reported earnings. The value in-exchange
approach will usually result in more of the initial purchase price being
allocated to goodwill, which must be tested for impairment every year.“SFAS 141 Impacts Choice of Method Used to Value PP & E” ---
http://www.valuationresearch.com/content/Knowledge_center/back_issues/35_2002_2.htm

C38. In the
context of the related guidance included in the Exposure Draft, some
respondents referred to possible conflicts between the in-use valuation
premise and the exchange notion encompassed within the definition of fair
value. In this Statement, the Board clarified that the exchange notion
applies regardless of the valuation premise used to measure the fair value
of an asset. Whether using an in-use or an in-exchange valuation premise,
the measurement is a market-based measurement determined based on the use of
an asset by market participants, not a value determined based solely on the
use of an asset by the reporting entity (a value-in-use or entity-specificmeasurement).Paragraph C38 of FAS 157 ---
http://www.fasb.org/pdf/aop_FAS157.pdf

Jensen CommentHence the FASB offers ambiguous guidance on exchange value versus value in
use. The FASB likes exchange value (VIE) in terms of objectivity relative to
the dastardly subjectivity of value in use (VIU). At the same time the FASB
hates exchange valuation that puts asset values at the worst possible use of
the asset, e.g. forced liquidation valuation of an asset that a going
concern has every intention of using at much higher value. Also there’s
absolutely no forced liquidation value for portions of fixed assets such as
enormous installation costs of ERP and other database systems, blast or
electric furnaces producing steel, factory robots, and assets requiring
millions of dollars in winning governmental permits, many of which are not
transferrable in liquidation sales. . Of
course at present, neither the FASB nor the IASB require fair value
accounting for most types of non-financial assets, including steel furnaces,
ERP, factory robots, etc. If the FASB extends fair value accounting to all
non-financial items, the FASB will most certainly have to back off priority
for objective exchange values for items having zero exchange value such as
non-transferable components of fixed assets such as installation costs.

The IASB is as inconsistent
as the FASB on issues of VIU versus VIE. The ideal is VIU that can be
objectively determined such as an asset or liability with contractual future
cash flows and minimal loss risk. As VIU becomes more subjective in terms
managerial choices as to the future cash flow stream of 200 hotels in the
hands of Days Inns versus Holiday Inns, then VIE is probably going to be
preferred by the FASB and the IASB. But this can be misleading, because
valuing hotels at a forced liquidation exit value may be more misleading
than historical cost book value when there’s no intention whatsoever for the
owner to sell the hotel. This would be especially misleading if Holiday
Inns had to use forced liquidation exit values in this period of distressed
real estate values where owners have no intention of selling out at
distressed real estate values. Of course
at present, neither the FASB nor the IASB require fair value accounting for
most types of non-financial assets, including real estate. If fair value
accounting is extended to all non-financial assets, I think that preferences
for VIE will have to give way to VIU. VIE likely to be highly misleading
(overly conservative) when trying to evaluate investment potential of a
successful going concern.

Value in use
issues also rear up in standards involving value impairment tests such as
Value in use [IAS 36, par. 18; IAS 38, par. 83]

Bob Jensen's other threads on fair value accounting are at various other
links:

No. FAS 141(R)-1 ---
http://www.fasb.org/pdf/fsp_fas141r-1.pdfTitle: Accounting for Assets Acquired and Liabilities Assumed in a Business
Combination That Arise from Contingencies Date Issued: April 1, 2009Jensen CommentThis is an illustration of a principles based "standard" that will be very
difficult to implement and virtually impossible to consistently apply among
different firms.

From The Wall Street Journal Weekly Accounting Review on April 16,
2009

SUMMARY: Since
most states must by law balance their budgets every year,
dwindling sales and income tax revenues during this economic
downturn have led to discussions about increasing income and
sales tax rates. "At least 10 states are considering some kind
of major increase in sales or income taxes: Arizona,
Connecticut, Delaware, Illinois, Massachusetts, Minnesota, New
Jersey, Oregon, Washington and Wisconsin. California and New
York already have agreed on multibillion-dollar tax increases
that went into effect earlier this year. Fiscal experts say more
states are likely to try to raise tax revenue in coming months,
especially once they tally the latest shortfalls from April 15
income-tax filings, often the biggest single source of funds for
the 43 states that levy them....[However,] many states remain
determined to balance their budgets by relying solely on
spending cuts. That is the case in Indiana, where raising
revenue 'is really not on the table,' said Pat Bauer, the
speaker of the state House." The article finishes with a
discussion of year over year comparisons and state revenue
forecasts used to assess what actions states must take in these
difficult times.

CLASSROOM
APPLICATION: The article can be used both to discuss state
tax levies in a tax class and to discuss governmental budgeting
in a governmental accounting class.

QUESTIONS: 1. (Introductory) As described in this article, what
are the major sources of revenue to state governments?

2. (Advanced) Why are states raising income and sales
tax rates when current economic times make it difficult for many
households even under current tax levies?

3. (Advanced) When can states best project their tax
revenues for the fiscal year? Why must they make these
projections?

4. (Introductory) For how long a period does Indiana
usually prepare its budget? What has changed in this year?

5. (Advanced) What Financial analysis techniques do
states undertake to forecast their revenues in order to decide
on their course of action? Cite all that you can find in the
article.

6. (Advanced) How do governmental entities include bad
debts assessment as part of the analysis described in answer to
question 5?

Looking for alternative uses of XBRL? Check out
with State Controller Kim Wallin is doing in Nevada. XBRL Ends
Spreadsheet Hell Tools Sponsored By

May 1, 2009, By Wayne Hanson

"The goals were timely and accurate data,
stronger internal controls, reduced costs, a standardized system of
seamless data exchange, business processes and data elements. XBRL met
all of those goals." -- Nevada Controller Kim Wallin (pictured)

States and localities have in recent years been
engaged in developing financial Web sites, transparency portals,
campaign finance disclosure and online checkbooks to open the process of
government spending to a very interested and sometimes skeptical public.
Recently, with the flood of federal stimulus money, that development has
accelerated.

While a commitment to openness and transparency
is commendable, tracking grants and other financial information --
across multiple agencies and departments running different software on
incompatible systems -- is a tough job for jurisdictions, and the
resulting information may be too late for real-time decision making, and
too complex for anyone but a professional auditor to understand.
Increasingly, XBRL is being heralded as a solution.

What is XBRL?

XBRL stands for eXtensible Business Reporting
Language -- an XML-based open standard for financial reporting. "Instead
of treating financial information as a block of text -- as in a standard
Internet page or a printed document -- XBRL provides an identifying tag
for each individual item of data," says an explanation on the XBRL
International Web site. "This is computer readable. For example, company
net profit has its own unique tag. In addition, the tags provide other
information about the item, such as whether it is a monetary item,
percentage or fraction, etc.

"XBRL can show how items are related to one
another," continues the site. "It can thus represent how they are
calculated. It can also identify whether they fall into particular
groupings for organizational or presentational purposes. Most
importantly, XBRL is easily extensible, so ... organizations can adapt
it to meet a variety of special requirements."

"The introduction of XBRL tags enables
automated processing of business information by computer software,
cutting out laborious and costly processes of manual re-entry and
comparison. Computers can treat XBRL data ‘intelligently' ... they can
recognize the information in an XBRL document, select it, analyze it,
store it, exchange it with other computers and present it automatically
in a variety of ways for users. XBRL greatly increases the speed of
handling of financial data, reduces the chance of error and permits
automatic checking of information."

Since Bernard Madoff was
arrested in December and confessed to masterminding a multi-billion Ponzi
scheme, countless people have wondered: Who else was involved? Who knew
about the fraud? After all, Madoff not only engineered an epic swindle, he
insisted to the FBI that he did it all by himself. To date, Madoff has not
implicated anybody but himself.

But the contours of the case
are changing.

Fortune has learned that
Frank DiPascali, the chief lieutenant in Madoff's secretive investment
business, is trying to negotiate a plea deal with federal prosecutors. In
exchange for a reduced sentence, he would divulge his encyclopedic knowledge
of Madoff's scheme. And unlike his boss, DiPascali is willing to name names.

According to a person
familiar with the matter, DiPascali has no evidence that other Madoff family
members were participants in the fraud. However, he is prepared to testify
that he manipulated phony returns on behalf of some key Madoff investors,
including Frank Avellino, who used to run a so-called feeder fund, Jeffry
Picower, whose foundation had to close as a result of Madoff-related losses,
and others.

If, for example, one of
these special customers had large gains on other investments, he would tell
DiPascali, who would fabricate a loss to reduce the tax bill. If true, that
would mean these investors knew their returns were fishy.

Explains the source familiar
with the matter: "This is a group of inside investors -- all individuals
with very, very high net worths who, hypothetically speaking, received a 20%
markup or 25% markup or a 15% loss if they needed it." The investors would
tell DiPascali, for example, that their other investments had soared and
they needed to find some losses to cut their tax bills. DiPascali would
adjust their Madoff results accordingly.

(Gary Woodfield, a lawyer
for Avellino, and William Zabel, the attorney for Picower, both declined to
comment. Marc Mukasey, DiPascali's laywer, says, "We expect and encourage a
thorough investigation.")